Banning structured derivatives no answer

Banning structured derivatives no answer
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First Published: Mon, Feb 22 2010. 11 35 PM IST

Updated: Mon, Feb 22 2010. 11 35 PM IST
Some large Indian companies have approached the Reserve Bank of India (RBI) to reconsider its proposed ban on “zero-cost structures, or structures aimed at reduction in cost of hedging”, according to The Economic Times. The central bank had made this recommendation in its draft guidelines on “over-the-counter (OTC) foreign exchange derivatives and hedging commodity price risk and freight risk overseas”, which was released late last year.
According to the companies, some zero-cost structures serve effectively in hedging currency risks, and should not be banned. Zero-cost and cost-reduction structures involve a long and a short options position. The premium received by writing one option offsets the premium required to buy the second option.
The advantage of this strategy is that it minimizes the cost of hedging. Some companies such as Tata Consultancy Services Ltd have a budget to serve its hedging needs and only buying put options to protect the downside of a sharp currency movement could prove to be expensive. Of course, they could use forwards to protect their risk, in which case there would be no outgo such as the option premium and budget constraints wouldn’t make any difference. But then, with forwards, while the downside will be protected, there is no upside potential. This would result in an opportunity cost, if the currency moves in the opposite direction vis-à-vis the forward position.
Some zero-cost and cost-reduction structures such as a long put plus short call position not only protect the downside, but also provide some upside potential. The downside and the upside cap will depend on the strike price of the two options contracts. Coupled with the advantage of a low outgo, this would serve the needs of some companies well, and it seems reasonable that they are allowed to use such strategies.
Needless to say, similar structures can be misused and there can be an attempt to speculate using currency derivatives rather than hedge risk. In fact, this had happened at a large scale a few years ago in India, leaving many firms with large losses. In some cases, the losses were so huge that the companies took the banks who sold these products to court.
This happened not only in India, but in many other emerging markets. According to an article by Randall Dodd, a senior financial sector expert in the International Monetary Fund’s monetary and capital markets department, companies across the spectrum of emerging markets entered into exotic derivative contracts that caused massive losses. An estimated 50,000 companies in the emerging market world have been affected.
While this concern remains, banning all zero-cost structures doesn’t seem like a good solution. In fact, RBI’s guidelines suggest that banks should be selling only plain vanilla products. Now there’s one view that one can hedge away 99% of all types of risk by using a combination of forwards and options. But it can’t be denied that some firms would require non-standardized products to hedge their risk effectively.
One could argue that the zero-cost structure can be replicated by simply buying a put option and writing a call option in two separate transactions. But then the draft guidelines also stipulate that companies can enter into only one derivatives transaction for every underlying exposure. With this restriction in place, doing the two transactions separately will lead to inefficiencies in hedging.
If such products are banned in India, companies would simply buy them in overseas markets, leading to an export of another section of India’s financial markets. The central bank needs to keep these factors in mind before framing final guidelines for OTC derivatives.
As far as the issue of mis-selling goes, Dodd says, “In at least seven Asian countries—China, India, Indonesia, Japan, Korea, Malaysia and Sri Lanka—plus Brazil, Mexico and Poland, the losses arose from very similar exotic derivative contracts traded between sophisticated derivatives dealers and their often less sophisticated non-financial corporate customers.”
The draft guidelines include some good suggestions to tackle mis-selling, such as quantifying the maximum loss or worst downside in various scenarios in the term sheet. Still, Indian companies need to exercise more caution while entering into derivatives contracts and signing the term sheet. The central bank should not be the one taking responsibility to protect them.
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First Published: Mon, Feb 22 2010. 11 35 PM IST