Companies punt in derivatives to meet guidance

The staff in the derivatives sales team of a British Bank, which is a relatively recent entrant to India, was pulling the leg of a new recruit. The new recruit had been told that the CFO of an auto ancillary company loved new and fancy derivatives structures and was always willing to buy. The new recruit was told that selling a new derivative trade to this CFO would be the best way to open his sales career in this bank. Unfortunately, the CFO did not buy. “You have no future in this place,” joked the recruits’ colleagues, “you couldn’t even sell a structure to him”!

As events unfolded, this bank and indeed many other banks, including several new generation private banks and foreign banks with large presence in India, have realised that this joke is hiding a grim reality. An entire rash of small and medium-sized companies are sitting on loss-making positions on their balance sheets and are trying to figure out ways so that they come out of this clean and so are their bankers who sold them these instruments.

In some cases like Sundaram Multipaper, a Rs 100-crore company, the efforts to contain the problem have ended up in court. In case of Hexaware, which may have a loss of $25 million, and three independent directors of the company are submitting a report on this affair to the board of the company.

“Right now Sundaram Multipaper is one of the most watched cases,” says a forex expert. This case in many ways symbolises the easy money that Indian corporates earned through their hedging operations for almost two years. Over the year ended 2007, income from forex gains had moved up by 44% while net sales moved up by only 40% for Indian corporates that are the part of BSE 500.

Even for the third quarter of FY08, corporate India is showing a slowdown in sales but other income component through forex is still high. “People in the forex market are calling it QSQT (quarter se quarter tak) effect,” says a forex consultant, making a cheeky allusion to Aamir Khan’s first film.

Under pressure to deliver numbers to meet profit promises (guidance), companies have been encouraging their CFOs to punt in the derivatives market.

One of the reasons that has prevented the entire episode from going public is that companies do not have to show notional losses (mark-to-market) regarding derivatives. For example, when a day-trader buys a share of Rs 500 in the morning and the share falls to Rs 200 at noon, he has a mark-to-market loss of Rs 300. If the share remains at that price when markets close, the notional loss is a real cash loss and he has to give that money to the broker.

The company may have to show their MTM losses due to change in accounting standard, not because the derivatives are designed like that. “If a company is holding a position that is making losses on the mark-to-market basis, chances are that bankers will narrow the credit line or in other words, demand for margins. Only when a margin call is triggered will companies take a hit and show a loss in their books,” says Nandlal Bhatkar, CEO of Pyxis Systems, a Pune-based company that builds solutions for derivatives markets.

Options, lies & ticker tapes

This has not happened in all cases though. In some cases CFOs have actually misled the board about their positions, for example, Hexaware. “The information regarding these transactions was intentionally withheld from the senior management and the board of directors and was not included in internal reports,” says Hexaware Technologies founder & chairman Atul Nishar.

Sundaram’s case shows why CFOs and banks ended up doing derivative trades that perhaps were not entirely appropriate. “We did not even have a formal banking relationship with ICICI. When we moved to a new premise, ICICI Bank was next door and so we opened an account there because of proximity.

Soon they started making business visits and invited our CFO to a seminar where he was shown how these derivatives can make good money for the company. He was fairly certain that we would make money, the board gave authorisation; beyond a point a small company like us does not understand these transactions,” says Amrutlal Shah, director of Sundaram Multipaper.

ICICI Bank on its part says Sundaram knew exactly what it was doing. “We have a voice recording in which the company’s CFO has given his explicit approval to the entire transaction. He even asks questions regarding the amount of profit or loss and there is explicit discussion on the potential risk of the transaction expressed in amount,” says ICICI Bank executive director Madhabi Puri Buch. It is for the courts to decide who is at fault, but it is clear that more than anything it is human nature — the desire to eat that free lunch — that is to blame.

Never take a bet you can’t afford to lose

Derivatives, like in most matters, of life are probabilistic. That means most derivative transactions are sold as “95% of the time this trade could make a profit and 5% of the time there will be a loss. Most people tend to take 95% part as a near certainty. This is completely flawed because there is simply no telling how much that loss will be. It can bring the house down,” says Mr Bhatkar.

Take one favourite derivative trade to understand why many companies had loans costing 10-12% per annum. These firms were beginning to hurt from the way interest costs were cutting into their profits. Many auto component and IT companies had revenues coming in dollars, and because with each passing money, a dollar was buying less rupees (rising rupee), the profits of these companies were declining. For instance, a company with Rs 200 crore in debt raised at 10% did not know how to reduce their interest costs.

Banks came to rescue of companies struggling with these problems. To reduce the interest outflow, they had to earn an interest “inflow”. The easiest and least risky way of doing this is to borrow $50 million in the currency of a country with low interest rate —mostly it was Swiss Franc where interest rates were 2%. An equivalent amount was lent in the currency of a country with higher interest rate, usually dollar where interest rate was 6%.

The interest rate differential (of 4% p.a.) multiplied by $50 million was the clear profit that reduced the actual interest impact. This nice profit can be wiped out if two chosen currencies change in relative value sharply. That is why the Swiss Franc (Swissie)/US dollar pair was chosen. Only once in the last 20 years had the Swiss Franc moved out of the band of 1.20-1.10 dollar per Franc.

Lure of lower cost protection

Having sold this “free lunch”, banks told corporates that they should buy a little insurance, just in case in there was an untoward movement in the Swiss Franc currency. To do this, companies paid a premium to buy the right to purchase Swissie if the currency appreciates. However, in order to reduce the cost, clients were offered the knock-out option. This options and the protection offered by them disappear if a certain even takes place. The event defined in some of these options was Swissie touching 1.09. Since at the time of entering, the option this looked extremely remote.

The same trade could have been created by combining a client buying a vanilla Swissie Call option (say at strike of 1.17) and selling a Swissie call option with strike of 1.17, but which only knocks in at 1.09. This cancelled the buy call option with a sell call option and exposed the client to a risk of appreciating Swissie, a completely unforeseen event.

According to RBI rules, an Indian corporate can never be the net receiver of premium in options. In simple words, corporates can buy “insurance” but they can’t sell “insurance” because the extent of financial loss can be very high in the latter. But if a corporate wants to make the entire trade a zero-cost one, it simply starts writing options to receive premiums that will nullify the cost of protection.

In spite of all the protection that companies tried to take, the rise of the Swissie was not taken into consideration. The Swissie moved by 10% over the last one year and is presently trading at 1.09 against the dollar.

The moment the Swissie breached the 1.10 level, the right to sell Swissie was cancelled and companies stopped receiving premiums. But the other leg of the “zero-cost structure” remained intact and premium payouts increased.
With every rise in this currency, the mark to market losses for Indian corporates will increase. They can choose to cancel the contracts but then they will have to show the actual cash loss in their books, so many are sitting on the losses and waiting for the tide to turn. But in such volatile markets, banks do not want to take a chance and thus they are forcing the corporates for margin calls. That’s why you see all these disputed now coming out.

“To be fair, these CFOs made fat profits in the last two years and nobody asked them how they were making such handsome hedging gains,” says a banker. One CFO of an auto component company that makes tonnes of money on hedging, used to go around mocking his production plant heads, saying he could deliver more profit in one quarter than what the production chaps could deliver in a year. “Why did his CEO and board not question him then? It is clear that they liked the money he was making,” says a forex consultant.

The sad fact is that most boards do not even understand the complexities of these trades. “There are a large number of boards that lack the expertise to understand derivative contracts. Ideally, it is the job of the audit committee to check this out but in many cases they do not have correct information made available,” says Nawshir Mirza, an independent director, who serves on the boards of Tata Power and Mphasis.

If this issue blows up, then most boards will have no option (pun unintended) but to appoint experts to examine derivative deals before they are signed. And banks will have to do some soul searching on whether their sold products to people who did not understand them.