Derivative Dilemma

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an appreciation for the exporter.

Enter exotic derivatives offered by banks. So, a company wanting to cover its $100 million exposure, could take $500 million bets through cross currency movements.

These financially-engineered products, developed by rocket scientists, worked well initially. A lot of money was made and then when the yen and franc market turned the other side, bets turned wrong.

A research report by Morgan Stanley suggests that exposure to exotic derivatives by Indian banks and branches of foreign banks in India tripled in December 2007, when compared with the figures in the same month of the previous year.

The impact

Normally, these contracts could have been extended or reworked so that when the markets normalised at a later date, some of the losses could be recouped. But then the ICAI ruling to have these losses accounted for with immediate effect will hurt. Already, companies like Hexaware Technologies, Amtek Auto and even the biggie Larsen & Toubro have come out inthe open and spoken about the extent of possible losses. “Many more skeletons will tumble out,” says Devendra Nevgi, CEO of Quantum Asset Management.

An SSKI research report suggests that around 70% of exotic derivatives exposure has been taken by large corporates, and the extent of exposure of small and medium enterprises is around 20-25%. This clearly means that mid-cap segment on the stock market is going to be extremely vulnerable.

“The larger companies will be able to take on the impact and the numbers will not be significantly lower. But the mid-cap companies will be shaken,” says TS Harihar, head of derivatives research with Karvy Securities. The divide between the large and the mid-cap segment will definitely widen, he adds.

Here the segment that is likely to suffer the most is the mid-range IT sector which has strong exposure.

Already, this segment has been taking a hit due to the US slowdown and the possibility of its effects rubbing off on other markets.

Commodity-based companies like those in the metals and chemicals business usually take smart bets on currency and commodity movements. While earlier most of these were genuine hedges, many have turned to these as a source of profits. These would be the ones that could get hit the most. Textile and jewellery players are also amongst those who are like to report derivative losses this quarter.