The Hindu Business Line : All about currency derivatives

Currency derivatives can be described as contracts between the sellers and buyers, whose values are to be derived from the underlying assets, the currency amounts. These are basically risk management tools in forex and money markets.

MR M. SITARAMA MURTY, FORMER MANAGING DIRECTOR OF STATE BANK OF MYSORE

Indian companies have, in recent times, grabbed headlines for all the wrong reasons. Swaps, options, exotic derivatives, structured product.the list is endless. As a shareholder, one has seen companies booking losses owing to `currency derivatives'. Naturally, everybody is petrified at the mention of currency derivatives.

Business Line sent some posers to Mr M. Sitarama Murty, former Managing Director of State Bank of Mysore. An expert in forex and money markets, he worked in SBI, Paris, during the critical years of 1990-93. Before that Mr Murthy headed the International Division of State Bank of Hyderabad at Chennai for more than six years (1984-90).

Have we seen the last of currency derivative losses in our corporates? Alas, the answer seems to be in the negative. "It is possible that some companies or even some of their auditors are not familiar with the new range of products and some more disclosures could come a little later," he warns. Over to the expert.

Excerpts of the Q&A:

First tell us about currency derivatives and what purpose do they serve.

Devoid of jargon, currency derivatives can be described as contracts between the sellers and buyers, whose values are to be derived from the underlying assets, the currency amounts. These are basically risk management tools in forex and money markets used for hedging risks and act as insurance against unforeseen and unpredictable currency and interest rate movements. Any individual or corporate expecting to receive or pay certain amounts in foreign currencies at future date can use these products to opt for a fixed rate - at which the currencies can be exchanged now itself. Risks arising out of borrowings, in foreign currency, due to currency rate and interest rate movements can be contained. If receivables or payments or expenditure are denominated or to be incurred in multiple currencies, derivatives can be used for matching the inflows and outflows.

Is it risk-free?

Market risks can't be avoided, but have to be managed. And currency derivative serve the purpose of financial risk management encompassing various market risks. As in the case of insurance, an upfront premium is payable for buying a derivative.

While there could be some gains, depending on the markets and market movement and the type of derivative selected, losses are contained. Entering into contracts not backed by genuine business cash flows in relevant currencies amounts to speculation and can lead to losses.

What is the difference between forex derivatives and currency derivatives?

There is a thin line dividing the two. Derivatives based on currency exchange rates are forward contracts (or forward rate agreements); options and swaps and are popularly known as forex derivatives. Those are meant to hedge interest rate risks and cash mismatches in different currencies such as currency swaps and options are known as currency derivatives. There are interest rate forward rate agreements and swaps for managing the interest rate movements risk within same currency. On the lines of commodity futures, there are currency and interest rate futures, which are nothing but standardised forward contracts. A committee appointed by the RBI (Reserve Bank of India) has recommended making available the currency futures at authorised dealers.

Tell us about forward contracts.

Forward contracts stipulate the rate as which a given currency can be exchanged for another currency as at a future date. Both importers and exporters or anyone with a certain amount of receivable or payable can protect the rupee inflows or outflows by deciding on a level comfortable or acceptable at which their profit can be protected and enter into a contract with their bank.

Irrespective of the ruling market rate on the day of the transaction, the contract has to be honoured or the difference between the market rate and the contracted rate has to be paid. In case the date of the transaction is to be advanced or postponed, the interest rate differential for the two currencies for the period involved has to be paid.

Then, how does it differ from an option?

An option is a `stipulated privilege' to deliver or receive an agreed amount of currency at a given price by a stipulated date. There is a basic difference between a forward contract and an option. In case of a forward contract, a right as well as an obligation are in-built, while an option confers a right to get the contract honoured but `no obligation to perform'.

If the ruling market prices are favourable, the buyer of the option can choose to ignore it. In the case of a forward contract, there could be an upfront gain or cost, depending on whether the currency being offered is in premium or discount in the forward market.

In the case of an option, an upfront premium has to be paid to the seller (writer) of the option. This premium depends on the strike price (the price at which the currency is to be received or delivered), the maturity date, and a view on the currency movements. In view of the superiority of this product from the customer's angle, the premium will be a small percentage of the amount of the contract.

Nowadays we hear a lot about the term `exotic options' in relation to currency derivatives. Why are they called exotic?

There could be a simple forward contract or option called `vanilla' product. Any variations, with a number of possible permutations and combinations built on the basic structure can be engineered to suit the needs or objectives of the buyer and make the product more attractive.

An engineered option can stipulate a rate at which the currency can be received or delivered and offer, as an `add-on', choice of another currency in addition to the originally stipulated currency.

For example, an option may stipulate that for every dollar of the agreed amount Rs 40 or 100 are to be delivered or received one month hence.

Because of the additional feature and the need to take a considered view with the associated uncertainties not just on the dollar-rupee rate but dollar-yen and yen- rupee rates also, the banker seller can charge slightly higher premium.

A forward contract could also be fashioned into an attractive offer and stipulate that if the dollar-rupee rate moves below Rs 38, the bank would compensate the exporter with the difference of the amount beyond Rs 38. Such a product is called a `Floor', which limits the risk of the exporter to the rupee appreciating beyond 38.

A combination of this product with a `Cap', which requires the exporter to share the gains with the bank should the rupee fall to 42 on the downside. The combination of the Floor and the Cap is named a `Collar'. All these variations of the basic products of forward contract and the options are known as exotic derivatives.

Many banks, as a marketing gimmick, lure the customers with such relatively rare exotic products. It requires deeper knowledge of the forex and interest rate markets and their behaviour to understand the implications and the risks and rewards involved carefully.

Many companies such as ICICI Bank, Wockhardt and Power Finance Corporation have booked forex/derivatives/MTM losses. It's very confusing. While ICICI Bank says that it has made provisions of $100 million in the last quarter of FY'08 towards mark-to-market losses on its derivative portfolio, Wockhardt says that they booked MTM losses of Rs 27.9 crore due to its long-term hedging instruments that were bought to reduce the interest costs for the company's loans. Are these cases different?

The cited cases are different in nature. A company which buys a derivative to hedge the risks over a relatively longer period would not incur cash losses on the accounting date as the contracts do not mature or get wound up and continue in the books of the company as off-balance-sheet items.

To comply with the accounting standards, these items need to be marked to the market and revalued as on the date of closure of books for a financial year.

It is similar to the exercise of revaluation of investments in bonds and securities traded on the market by institutions such as banks and corporates, though they continue to be held on the books beyond the date of finalisation of accounts or maturity. Depending on the interest rate movements, the price of the securities can either improve or worsen and depreciation has to be provided for out of the profits. Such losses are, however, considered notional till the maturity date or till assets are liquidated.

Normally the banks, the sellers of the derivatives, cover their positions in the inter-bank market by doing the opposite of the deal done with their customer with another bank.

This is akin to reinsurance. The spreads in the inter-bank market are finer. In the absence of any open positions, the derivatives are not subject to any losses. The normal premiums and costs incurred are debited to expenditure. If, however, a bank chooses to keep certain positions open and uncovered, in anticipation of the markets to turn in their favour enabling them to make profits by unwinding them at an appropriate time, the derivatives need to be marked-to-the-market and any loss arising as on that date has to be shown as losses in the balance-sheet.

If a company has un-hedged exposures in foreign currency on account of borrowings, and the rupee depreciates against the borrowed currency, there could be a loss requiring disclosure. Though this is not a direct business loss, it adds to the liability and as such impacts the balance sheet. It is possible that subsequently the rupee might appreciate or regain the lost ground; but, what is relevant is the rate as on the day of the closure of the books. The deficit on the date is considered a notional loss as the liability has not crystallised and there is no outflow of rupees.

PFC says that its fourth-quarter profit fell 20 per cent because of losses on foreign-currency borrowings after the rupee appreciated.

In case of PFC, the currency of borrowing and the rate that prevailed at the time, the loan was converted into rupees (assuming that it was utilised for rupee payments or investments) are not known. Even if the loan in foreign currency is used for meeting the payments in the same currency, the liability will be converted into rupees, the home currency, and shown as a liability in the books. Any changes in the converted value as on the date of closure of books have to be accounted for. If the company has matching assets in the same currency, or has assured and proven inflows, or the exposure is hedged, need for even notional losses should not arise.

Is rupee to blame for the losses booked on currency derivatives?

No. Derivatives are meant to provide protection against currency fluctuations. Based on the business needs, if an acceptable level of rupee is predetermined and appropriate hedging done, rupee appreciation could not be the cause for losses. Even if the rupee had moved in the other direction than expected, i.e., if it had depreciated, it would be only an opportunity loss and not a cash loss. Where complex and structured derivatives are bought with a view to gain from possible rate movements in currencies other than in the invoice currency, losses could arise.

Give us an example.

For illustration, some exporters, instead of booking simple forward contracts or options, resorted to currency swaps, an chartered territory, opting to convert the receivables into a third currency such as the euro, Swiss franc or yen, in anticipation of appreciation of these currencies against the rupee.

Interestingly, some importers (or their bankers said so) took an opposite view and opted to pay in yen, expecting it to depreciate vigorously against the US dollar. Yen in fact has moved both ways going up to 95 and going down to 110, presently hovering around 103-104 range. It is a complex exercise to take a view simultaneously on the future of rupee-dollar, dollar-yen and rupee-yen. In normal times and in spot markets, evening out the hedging opportunities, the rates move in tandem; but the forward rates will depend on the respective economies, balance of trade between the countries, the interest rates in these currencies and even the demand and supply position for the currencies as on the date of the transaction. Banks seem to have successfully convinced the exporters and importers and marketed their structured currency swaps. While possibly a few have gained, many have lost.

How can instruments meant to insure against future losses really dent a company's profits? Are they not 100 per cent effective?

If a corporate decides on a comfortable level of rupee, there is a small gain or cost attached to the forward contract or option. If, however, complex multi-currency exchange rate or interest rate swaps are contracted, with a view to make money, losses could arise. Cases where corporates themselves have written (sold) options to earn income or to speculate on the currency movements, based on their own perceptions or their bankers advice, also are in for trouble. Clearly, trading or speculation for gain could be some reasons. It is also possible that to avoid payment of the charges or premiums or not to get themselves tied to a rate and thus lose possible gains should the currency move in their favour, some chose to keep the exposures partly or fully uncovered..

Anxiety on the part of the banks to book more business and possible over-enthusiasm on the part of the corporate finance executives to make profit from this `non-business' could be the other reasons. A company's business is to make profits by selling their products or services and not out of currency or interest rate movements. If incidentally they get an opportunity to gain, it is fine.

Another area where corporates and banks have not come clear has been marked-to-market losses. Are these notional or real losses? Why mark them to market and mention them in the profit & loss account if they are merely notional?

Though as on the given date the liability doesn't crystallise, it is a prudent accounting practice that all the derivatives in the books are marked-to-market as on the date of the book closure. The ICAI (Institute of Chartered Accountants of India) has also issued a Standard in this regard recently. If the contracts run to their full course, no losses would arise. Uncovered exposures in foreign currency receivables and payables also need to be marked-to-market for evaluation on the given date. The resultant deficits or losses are notional in nature, as the rates might change either way subsequently and could result in loss or profit on the day they are converted into rupees.

Small and medium enterprises and even some larger corporates have accused the banks of `mis-selling' derivative products. What would have been the incentives for banks to mis-sell such products? Are companies enabled enough to check their derivatives exposure?

A buyer of goods or services can't blame the seller for any losses unless the terms of an agreement or the specifications are violated. One should understand what one is bargaining for. Ignorance can't be cited as reason. Some corporate managers sign on the dotted lines, impressed by the high-flown jargon, complex formulae, attractive drawings and colourful charts which the young and smart bank executives use for marketing their products. Banks do have a responsibility to educate their clients and to offer only suitable derivatives. With the offer of a carrot of extra profit, banks lure the customers, and earn a fee. In some cases, the banks use the customers' positions to create positions in their books with an eye on opportunities to make money for themselves out of the future favourable market movements. Corporates need to equip their finance executives with necessary skills to evaluate the derivatives before venturing into untested waters. It is equally important to monitor the outstanding derivatives at management/board level and take appropriate steps to minimise the losses.

Is this round of losses announced by corporates the last or they could get bigger in future?

Market values of open and unexpired derivative positions could turn either way. Even notional losses could change into notional profits. Unless full disclosures are made, it is difficult for a lay person to predict. It is possible that some companies or even some of their auditors are not familiar with the new range of products and some more disclosures could come a little later.

Many companies have come out with statements that the losses that were made were not because of speculative trading. Do companies really indulge in speculation with money meant to protect them?

Much can be said on both sides. A number of companies might have entered into exotic and speculative contracts with half knowledge and are pleading ignorance now.

With receivables or payables in US dollars, to enhance the profitability arising out of expected rate movements, if they enter into dollar-euro or dollar-Swiss franc swaps, where a view has to be taken on more than one currency, it amounts to speculation.

Instead of fixing a rupee rate and choosing a forward contract or an option if the company chooses to strike a deal for a currency option or leaves the positions uncovered, gain or loss is inevitable most of the times. The RBI has been advising the banks to market only plain vanilla products and offer derivatives to only those who have genuine outflows or inflows in the chosen currencies. This doesn't appear to have been heeded to strictly.

Is it possible for the common investor to know whether their company has engaged in speculative or protective measures through the use of currency derivatives?

Investors in a company with good corporate governance or smart auditors can hope to know the truth. Only persons with special knowledge can scrutinise the balance-sheet with a fine-toothed comb and scent any trouble brewing.

What are the common causes for making losses on currency derivatives?

Expectations on the currency movements going wrong are the main reason for losses. Though intended as risk mitigating measure, entering into structured derivatives such as currency swaps, swaptions (a combination of a swap and option) itself is fraught with risks, which have to be assessed properly. A reasonable amount of speculation is an essential ingredient of any business, but not adventurism spurred by greed.

Some Indian companies focus on risk management. Is risk assessment done with the same enthusiasm?

Risk assessment is critical to risk management. Identifying, measuring, monitoring and mitigating the risks are the components of risk management. All business units having cash flows in more than one currency need to have a critical view of their cash flows currency-wise, to manage the surpluses and deficits through judicious use of hedging techniques. In a globalised era, multi-currency balance-sheet management would be crucial to the bottom lines. It is possible that without relating the need for a derivative to the assessed risks but looking to the possible gains out of the deals and largely depending on the marketing strengths of the banks contracts are entered into. It is like Abhimanyu entering the chakravyuha!

D. MURALI

KUMAR SHANKAR ROY

http://InterviewsInsights.blogspot.com

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