Is there light at the end of the tunnel?

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Thursday , May 08, 2008 at 2358 hrs The spectre of being wiped out of business looms large over many companies as they count their losses on account of forex derivative positions held by them. Volatile currency movements over the last few months have meant that companies across the board, from small to large, have suffered thanks to derivative positions held by them, which is a tool used for both hedging and trading their underlying currency exposure.

Typically companies who deal in foreign exchange, mainly exporters and importers, hedge their underlying exposure. But the smart ones go a step ahead – they also trade their underlying exposure to book profits. This is done with the help of structured instruments sold by banks. “RBI rules stipulate that corporates cannot be a net receiver of premium,” says Chiragra Chakravarty, principal consultant, Pricewaterhouse Coopers. “To ensure that RBI rules are not flouted, banks and corporates sell options to each other and the premium charged is netted off to make it zero-cost.”

What complicates matters is that banks have very exotic products on offer to hedge and trade risk. Companies with no proper understanding of it could get trapped. At least that is what happened in the current case.

Prior to the sub-prime crisis in the US, which reared its ugly head in the second half of last year, most companies were making substantial profit on structured derivative transactions on account of the dollar being strong against currencies such as the Swiss franc and Japanese yen. Says NS Venkatesh, managing director and chief executive officer, IDBI Gilts, “For almost three/ four years, the Swiss franc to a dollar stood at 1.20 CHF, never going beyond this mark. Even the yen to a dollar was pretty strong at 110.”

Following the default rate going up substantially in the sub-prime mortgage market in the US resulting in a number of key banks reporting huge losses, the dollar already weak against the Indian rupee, became equally weak against other international currencies including the Swiss franc and Japanese yen. This meant that companies who held large positions in derivatives of these currencies were not able to book the profits they had anticipated. Instead they had a loss on hand. Says a banker on condition of anonymity, “What took everybody by surprise was the speed with which it unfolded.”