The Indian companies that are now nursing derivative losses had failed to remember an old rule—the past is an imperfect guide to the future. They got into derivative deals believing that the prices of currencies, bonds and commodities would remain on the straight path of predictability. There were, however, a few sharp turns in the road, thanks to the global credit crisis. Many companies did not anticipate these turns and have thus ended up in the ditch.
Derivatives are contracts whose value is derived from another price. So a currency derivative derives its value from the price of the currencies on which it is based. Similarly, there are derivatives on bonds, interest rates, equities, commodities and much else. A move in the underlying price usually leads to a change in the price of the derivatives that are based on it.
Consider the way the US dollar and the Swiss franc have moved against each other. This particular exchange rate is important because three of the misfired derivative bets that have landed in the Indian courts over the past few weeks were based on the relationship between the two currencies.
Between September 2006 and September 2007, the dollar-franc exchange rate moved in a tight band of 1.20 to 1.27. That’s all of seven basis points (a basis point is a hundredth of a percentage point). Bloomberg data shows that there were a mere 13 days during these 12 months that the dollar stepped outside this narrow corridor. So, anybody looking at that currency chart in the middle of last year would have been tempted to conclude that this remarkably stable relationship would last over the coming months and years.
It seemed a fine time to make a few “safe” bets on the dollar price of a Swiss franc. Actually, it wasn’t.
Knocked out by knock-ins
On 22 June 2007, the Swiss franc traded at 1.2355 to a dollar. That was the day when Rajshree Sugars and Chemicals Ltd entered into a complex derivatives deal with Axis Bank Ltd. The derivative was based on the movement in the exchange rate between the US dollar and Swiss franc. Two other deals that are in the courts—between Sundaram Multipap Ltd and ICICI Bank Ltd and between Sundaram Brakes and Linings Ltd and Kotak Mahindra Bank Ltd—are also based on the dollar-franc exchange rate. All three deals have a similar structure of pay-offs. Sifting through the details of such deals tells us a bit about what went wrong.
Mint showed the documents, presented to the Madras high court by Rajshree Sugars and Chemicals, to a foreign exchange adviser who has requested anonymity. He explains that the deal was based on three scenarios.
First scenario: In case the dollar-franc rate moves by 30 basis points on either side of the spot price on 22 June 2007—either to 1.2385 or 1.2325—the bank pays the company $100,000.
Second scenario: If the rate touches 1.2385, the deal gets “knocked out”. It ceases to exist and neither company nor bank has any liability.
Third scenario: If the exchange rate touches 1.1250/1.200, the company has to buy $20 million from the bank at the rate of 1.33 francs for every dollar. Thus, 1.1250/1.200 is the rate at which the derivative deal “knocks-in”.