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Deriving Losses

In the past few months, India has seen major losses in currency derivatives. While the reasons behind the losses are many, experts believe that they could deepen further due to the sensitive markets

In the last couple of months, we've learnt India Inc. is badly exposed to turmoil in global currency derivatives. In Q3, 2007-08, Hexaware Technologies recognised a loss of over Rs 100 crore on bad forex deals. Then, ICICI Bank provisioned for a potential loss of Rs 1,000 crore. More recently Amtek Auto revealed that it could be exposed to potential loss of Rs 70-odd crore.

These losses could snowball. One problem is that it wasn't mandatory for companies to declare off-balance-sheet exposures. The ICAI (Institute of Chartered Accountants of India) has held an emergency meeting to tighten disclosure norms but changing accounting standards will only start to reflect in Q4. In Parliament, the Finance Minister said, as on December 31, 2007, Indian banks had (including client positions) about $3.16 trillion of derivative exposures. A one-percent loss would be $3.16 billion - experts are saying that losses of this order or more, are realistic.

Several legal disputes have arisen between financial service providers and clients, alleging mis-selling and misrepresentation of derivatives. That has added to the uncertainty and fear factor.

An understanding of the mechanics could help in understanding how this exposure arose. While currency derivatives can be very complicated, most Indian exposure is not. The losses have arisen due to unusual forex volatility. The USD has depreciated sharply and US interest rates have also fallen much further than expected.

Most Indian companies with derivative exposure originally entered to lower overseas borrowing costs. Most had dollar exposures and shopped for the cheapest way to cover USD obligations.

They turned to Yen and the Swiss Franc as the best bets. In March 2007, the Yen was available at 118 per USD and benchmark JPY interest rates were about 0.5 per cent whereas the US$ benchmark rate was above 3.5 per cent. One obvious strategy for funding USD exposure was to borrow Yen, pay low JPY rates, convert to USD and hedge against the possibility that the JPY would appreciate versus USD. Most corporates used currency swaps for the initial transaction. In a currency swap, two parties exchange a fixed amount of JPY for USD. The Yen borrower can exchange into USD and receive USD interest rate while paying a JPY interest rate, and vice-versa. In fact, the two parties net off rate differentials -that means the Indian corporate is receiving the much higher USD rate from the Japanese counter-party so the transaction looks favourable. But at the end of the swap, the two parties exchange back exactly the same amounts of currency. If there has been a rate change in the swap period, somebody must lose. An Indian corporate entering a swap must guard against Yen appreciation. Most corporates used derivatives to hedge since these are cheaper than normal forwards. Specifically, they used barrier options.

A barrier option is a call option with a ceiling or barrier. For example, a barrier may give the holder the right to buy Yen at say 120/ $ on a certain date provided the Yen has not hit the barrier of 110/ $ in the swap period. If the barrier has been hit, the call option is cancelled or "knocked out" and the holder is left naked to currency risks.

Variations of this have happened in most cases where Indian corporates are in trouble. The bulk of exposures are JPY, a smaller proportion is Swiss Franc. In end-March 2008, the Yen is hovering at the 100/USD mark and Yen interest rates have stayed more or less stable while US rates have fallen to 2.25 per cent.

At least one Japanese I-Bank, the Mizuho Corporate Bank has predicted the Yen could rise as far as 85/USD. That could be absolutely disastrous. Since interest rate differentials have also reduced, even interim gains have been less than anticipated.

A further factor of uncertainty is that losses are booked only as and when swaps mature and the rates on that maturity date would be the key factor. Of course, there's a small chance that some derivative users will get off scot-free if the Yen-USD does correct back by the time deals mature. But those who have had their options knocked out will have to make normal forward deals at normal rates. Given already weak sentiment, this could cause another stock market crash.