Derivative Dilemma

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At the moment, the temptation to be like an ostrich and bury your head in the sand till the storm gets over is extremely strong, says a wealth manager with a leading multinational bank. And this is not without reason.

At the beginning of the year, his clients were upbeat and would call him up to seek advice on which areas to place their monies. Now, they keep hounding him, some panic-stricken, threatening to pull out their funds. The spate of bad news does not just seem to abate.

Last week, the Institute of Chartered Accountants of India (ICAI) announced that companies will have to report and provide for losses incurred on their derivatives portfolio with immediate effect. The rules that were to be applied two years later were preponed. And, many companies could well have to take losses on their books and see their share prices taking a beating.

While things remain uncertain yet, it is estimated that the extent of losses can actuallybe significant. Experts reckon that the losses could be in the range of $1 billion to $5billion. If it is on the higher side, Rs 20,000 crore or 7% of the estimated annual net profit, around 3,000 large companies will be wiped off.

Party pooped

The party which lasted for 15 quarters, where sustained growth in earnings was reported, can actually be pooped. And the writing was on the wall. Reporting such phenomenal numbers on a sustained basis was always a difficult task. “The old tenet of economics that super-normal profits don’t last, equilibrium has to be met is being realised,” says an investment banker, not wanting to be named.

He is not without reason. Numbers for the third quarter of FY08 show that other income for companies (sample 3,000) had grown by 62% over the previous quarter and this had contributed significantly to the 30% growth in net profit reported by India Inc. In fact, other income, which constitutes earnings from non-core activities like trading gains, was around 38% of the profit before tax – the highest ever in the last 15 quarters.

So when corporates were pulling wool over investor’s eyes, they themselves were getting gypped, reckons a senior executive with a leading audit firm. Normally, companies with a foreign exchange exposure would take a simple forward cover, pay the charge for the cover and then insure against adverse foreign exchange movements.