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.'
— '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.’
— ‘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.'