Further, a huge chunk of the nominal amounts outstanding as far as foreign exchange derivatives go were relatively less risky forward contracts. In a speech given at a seminar on the Indian derivatives market in Mumbai on 24 October 2007, RBI deputy governor Shyamala Gopinath gave some hints about the nature of derivative positions in bank balance sheets. She said the total amount of foreign exchange contracts outstanding amounted to Rs44 trillion. Of this, “almost 84% were forwards and the rest options”. The outstanding notional amounts for cross-currency swaps were another Rs 2,24,000 crore. Rupee swaps—which are largely between banks—were another Rs64 trillion.
The fears that toxic derivatives could choke the financial system and harm the entire economy seem overblown. RBI governor Y.V. Reddy said in a statement in April that while RBI is monitoring the situation and is in “constant dialogue” with some banks, there are no systemic risks.
Counting the damage
It is now time to count the damages.
How the losses will be totted up will depend on the precise nature of the derivatives that companies and banks have entered into. The easiest ones to deal with are what are called exchange-traded derivatives. These derivatives have a daily market quote, similar to the daily price of a listed share in the stock exchange, so marking them to market is not much of a problem.
The OTC derivatives that have been privately negotiated and are not traded will present more difficulties to accountants. The most popular way to put a value on them is to use the Black Scholes option-pricing model that is used the world over. “Unless options are listed and traded in the market, the Black Scholes model will be used to value what companies and banks hold,” says Gautam Nayak, partner in audit firm Contractor, Nayak and Kishnadwala.
This iconic valuation model was unveiled in 1973 by financial economists Fisher Black and Myron Scholes. Their widely used formula—which Indian accountants are likely to use—takes many factors into account: the price of the underlying asset, the strike price of the option, the risk-free rate of interest, the time in years for the expiration of the option contract and the implied volatility.
Rising interest rates and higher volatility in the financial markets could lead to steeper falls in the notional price of options in the months ahead. The global derivatives market continues to gasp for air—and banks with credit derivatives will have to keep more money aside as provisions.
We have not yet seen the end of the great Indian derivatives mess.
Venkatesha Babu in Bangalore contributed to this story.