Software services firm Hexaware Technologies has said that it faces between $20 million and $25 million of losses from currency options that its senior management says were not authorized. Currency options are derivative contracts that give the holder the right to buy and sell a currency at a certain price, though there is no obligation to do so. Hexaware Technologies’ option losses could wipe out the entire profit that the company is expected to make in the first three quarters of the current financial year.
There are broader lessons to be learnt. Many experts have voiced concerns over the past year that Indian companies have been taking derivative bets without fully understanding the risks involved. Many small companies, too, have jumped into the fray, as they try to buy protection against currency and interest rate movements. Hexaware claims that its losses are the doing of a rogue trader, but there could be other cases where the wrong bets have been taken with full knowledge of the treasury heads.
Many more such instances are likely to crop up in the years ahead, as the regulators introduce a wider range of derivatives to hedge against the inevitable fluctuations in financial prices. Companies will adapt to this and learn to use derivatives to their advantage. But every once in a while, there will be cases of derivative losses that will leap into prominence. These are the outliers. It is easy to misjudge their importance and ask for a rollback of financial market reforms. That is unnecessary. Derivatives are part of any modern financial toolbox—a few cases of losses should be ignored in the larger scheme of things.
But there is one lesson to be learnt from instances such as what has happened at Hexaware Technologies, where deals are struck below the reporting and compliance radars. This is an issue that we have commented on before. Derivatives can be a double-edged sword, which is why companies need to put in place very strict governance norms about what types of derivative contracts can be bought, who can buy them, what are this trader’s limits, etc. All this has to be viewed within the company’s overall risk strategy. In other words, strict oversight is necessary.
There have been many cases where rogue traders have wrecked entire companies, as the headquarters did not know what was happening in the trading room. Think of Barings, Sumitomo and Long Term Capital Management. In the case of Barings, for example, London had little clue about what Nick Leeson was up to in Singapore. The board of directors and the senior management need to keep a tight watch of what options and exotic derivatives are being traded.
Lack of knowledge is one issue that company managements will have to deal with, especially the managements of small companies that do not have quant traders sitting in their treasury rooms. There is clear information asymmetry—banks have been known to aggressively push derivatives in the market to companies that do not quite know what they are buying. One knows more than the other. Here again, the answer is not regulation but trying to move up the learning curve.
Legendary investor Warren Buffett says that exotic derivatives are weapons of financial destruction. The ongoing credit crisis in the West is partly because of the alphabet soup of derivatives that banks and investment houses have bought. India right now is gradually introducing very basic derivatives that have shown their utility in the developed markets over the past two decades or so.
A couple of losses here and there prove little. But companies should study incidents such as the recent one at Hexaware Technologies carefully, so that they can tighten their oversight, compliance and risk strategies.
What do Hexaware’s option losses signal? Write to us at firstname.lastname@example.org