Playing with fire — IMF

playing with fire — IMF

by Randall Dodd,
Senior Financial Sector Expert in the IMF's Monetary
and Capital Markets Department.

'Firms across the spectrum of emerging markets entered into exotic derivative contracts that caused massive losses.'

Snappy but potent

— 'Derivatives sellers often give snappy names to exotic derivatives as part of their marketing effort. KIKO stands for “knock-in knock-out” option—“knock out” representing the point at which further investor gains are cancelled. TARN stands for “target redemption note,” signifying that further gains would end after they reached a “target redemption” amount. TARN is also often used to refer to a forward or swap. Other comparable derivatives include Snowball and Accumulator, whose names evoke their potential for accumulating extra gains (and losses).'

— ‘An estimated 50 000 firms in the emerging market world have been affected. This includes 10 percent of Indonesia’s exporters and 571 of Korea’s small and medium-size exporters. Losses in Brazil are estimated at $28 billion, in Indonesia at $3 billion, and in Mexico and Poland at $5 billion each. Not all the losses are private. Sri Lanka’s publicly owned Ceylon Petroleum Company lost $600 million, and China’s Citic Pacific suffered $2.4 billion in losses.’

There are two fundamental questions:

— ‘Did the firms intend to hedge — that is, insulate themselves from currency movements — or speculate?

And did banks, acting as derivatives dealers, merely meet the needs of their clients or did they engage in deceptive trading practices?’

You be the judge.

• 'Potential gains on the transaction were capped or limited. In some cases it was a so-called knock-out provision that canceled the monthly payment if the foreign currency appreciated beyond a specified exchange rate, while in other cases the contract would terminate if the accrual of gains reached a target amount.'

• 'Potential losses were not limited, and indeed the derivatives were structured in such a way that the losses would occur at a rate that was usually twice as fast as the decline in the underlying exchange rate or reference price.'

• 'The initial cost or premium to enter into these transactions was zero.'

— 'Even if firms intended to speculate, these derivatives were far from the best instruments. Either a currency future or a standard forward or swap would offer the same or better upside potential, while not exposing the speculator to doubled downside risk.'