The following article is written in high spirits by our very own :
Ashish Gupta( Sallu).All those who feel they can add to these topic or criticize this are welcomed...
After the ‘subprime’ mayhem the next buzz word around is the ‘exotic derivative’. The same is being touted as the subprime of Indian market. Let us look at the reasons for a sudden increase in the usability of the word among the group that call themselves as ‘financial experts’.
When the Indian currency touched Rs. 40/ dollar, several banks wooed exporters and convinced them to trade in derivatives to hedge foreign exchange risk. It is very well known that traditionally, companies with huge foreign exchange exposures hedge their foreign exchange risk by entering into simple option contract that would guard them against any adverse price movement of the home currency vis-à-vis the foreign currency.
However, in recent times, exotic options, known for not being easy to understand, came into demand. Notwithstanding their complex nature, banks and companies took exposures in these products. Banks were happy with their bulging commission and the companies were happy with their small ‘other income’ that these derivatives provided apart from hedging their foreign exchange risk. The inherent motive that was their for companies in buying those exotic derivatives was not only hedging, rather it was coupling hedging with profits, which is better known as speculating. The company didn’t know that by doing this they were actually taking exposures in the currencies in which they had no business dealings. They were speculating on USD to strengthen against other currencies such as yen, euro and swiss franc.
However these currencies soared against the dollar, resulting into huge mark-to-market losses for the companies. Their position became worse when they couldn’t cancel the option as it would require them to take these losses to their books of accounts. Not to mention that they were also unable to comprehend the implications of the new accounting standards issued by The Institute of Chartered Accountants of India stating procedures for companies to account for their mark to market losses on derivative products in their books of accounts. Thus the losses accumulated and then started the ‘blame game’.
Companies instituted legal suits against the banks that they have mis-selled the products to them, i.e., they were not informed of the speculative nature of the product and were ‘lured’ into these bets by projecting them as mere hedging instrument. They claim that the banks didn’t inform them about any downside risk. To which banks replied that in the past when the companies made huge profits, no such complaints of misselling were aired. Moreover they questioned the contracts on legal grounds terming these contracts as ‘wagering’, prohibited under the Indian Contract Act, 1872. Thus they claim the contract to be void ab intio, i.e. the contract is null since its inception. Thus the banks are under a huge risk of losses as many companies have refused to pay for their mark to market losses and this may be aggravated if the court rules in the favor of the companies. A silver lining for the bank is that most of such contracts were entered into by large size corporate houses having regard to their credit worthiness and it is only the mid size or small size companies who have refused to pay for the MTM losses. Apart from this a lot depends on the decision by the court.
Recently, many companies which have filed cases against the banks have opted for the out of court settlement with the banks.
This exotic derivative can thus also be termed as the financial ‘Titanic’ for the Indian financial market, which though appeared to be very beautiful at the start, ultimately met with the ‘iceberg’ of financial illiteracy.
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