Three Indian companies have already been shaken and stirred by the turmoil in global financial and commodity markets.
Hexaware Technologies said in November that it could end up with losses of between $20 million and $25 million because of losses in option trading.?Last week, ICICI Bank had disclosed that it had written down $264 million of investments in credit derivatives. And Larsen and Toubro admitted on Monday that one of its subsidiaries could lose $49 million because of commodity hedging bets that went wrong.
On Tuesday, finance minister P. Chidambaram said that exposure of banks operating in India—including foreign banks—to derivatives grew 291% in two years to reach Rs127.86 trillion by end-2007. We won’t be surprised if there are more revelations in the months ahead. It would be unfortunate if that would lead to demands to roll back financial sector liberalization in India. It’s easy to make the argument that it’s all too dangerous for the Indian economy.
There are several reasons why companies could lose money. And derivative bets are one of them. Asking for a ban on derivatives because a few companies lost money is akin to putting a stop to acquisitions because most of them destroy shareholder value. These are decisions that need to be left to shareholders and the board of directors that are meant to represent them.
But there are other issues to be dealt with—especially those which deal with governance and regulation.
Regulators have to ensure that the derivatives markets are strengthened with better reporting and accounting standards. Companies will have to make sure that the internal risk managers and boards have a good idea of what is happening in the trading room. And smaller companies will have to be careful about what derivatives they buy from overzealous banks, since they are constrained by inadequate understanding and asymmetric information.
We know it’s easier said than done. The recent turmoil in the West shows that most of these safety valves did not function. The focus should shift to the incentives that make traders and CEOs take dangerous risks. To paraphrase what the American gun lobby says: Derivatives do not kill profits; people do.
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