The derivatives scare

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swaps, for instance, lets companies access cheaper interest rates overseas (FCBs) and swap that with their domestic rupee cash flow. This directly impacts the cost of capital. So, what went wrong? If a company has minimal transactions in, say, the Swiss franc in its operations and does not hedge through a reversing trade—it is taking a directional bet on currency movements and interest rates. In plain English, it is speculating. This is best left to people better suited for the job and who have the risk management tools to limit exposure. And even they lose very often.

How did Indian corporates get into a mess? A bull market has inherent momentum which makes some short order punts look like sure bets. An unexpected change, say unusual strength in the US dollar, can drastically change things, and if you are holding an open position, you’re in trouble. A look at annual reports for 2007 will leave no doubt that companies were quite active in these markets. That is a clear problem for investors. You bought a company for its core business. If you wanted directional bets on the market, you would have gone to a hedge fund. Being off-balancesheet, these transactions are difficult to spot. The only reason companies should be using these instruments is to hedge cashflow risk not inherent to the core line of business—retain the risk they are paid to manage and transfer the rest to people better suited to it.

But this is easy money when things are going your way—the lure is real. But once markets turn, all sorts of excuses and alibis are exchanged. Derivatives are a zero-sum game: your winnings come directly out of the coffers of the counterparty. These are also wasting assets, that is, they have defined life terms, so their value drops with each passing day. Unlike stocks that can recoup losses over time, derivatives have to be closed to avoid further losses. That brings in the spectre of “marking” these products “to market”, which means that they will now show up on balancesheets. This explains why companies have found religion all of a sudden. Banks, on other side of these trades, are not unscathed either.