The Hindu : Potential minefield for banks

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Monday, Mar 01, 2004

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Potential minefield for banks

Derivatives can be highly complex contracts and, used with little or no knowledge of the implications, can prove extremely destructive, says R. Viswanathan

Staffers at the Market Services Center of the London International Financial Futures and Options Exchange. — Bloomberg

`DERIVATIVES ARE financial weapons of mass destruction', said Warren Buffet, the second richest person in the world and arguably the best known financial wizard in the U.S. Alan Greenspan, Chairman of Federal Reserve and the most powerful central banker, has reportedly claimed that derivatives helped the financial system to ward off the effects of the dotcom bubble; there was no meltdown in the system even though the stock markets got a severe drubbing. It can be said that the four well known derivatives have the undoubted potential of WMD and one latest form of derivative may deserve the accolade of Mr. Greenspan.

Derivatives are contracts that have no intrinsic value, but are based on the value of an underlying commodity, currency or an instrument like stocks. These were originally used in commodity markets by merchants and farmers to ensure a firm price for a commodity at a future date. The four main forms of derivatives are forwards, futures, options and swaps.

Forwards and futures

Forwards and futures have a hoary past. Reports have it that these were used in Japan by farmers and merchants even in the 1700s and in the U.S. over two centuries ago. For example, if a miller in the U.S. ordered wheat from Europe (well before the U.S. became a wheat granary), at say $80 a tonne, the shipping time taken for him to get the wheat would be a month or so. However, when he sold the goods on arrival in the U.S., he will get the then ruling price; if that price was $70, he will lose. To get over this uncertainty, he entered into a derivative contract with a local dealer by which he agreed to sell the goods at a firm price (say $85) after one month. This is a typical forward contract and can be used for hedging, that is, insurance against uncertainty in prices.

Forward contracts had one major drawback in that one of the parties could renege on the contract. Thus, if the price ruled at $70 after one month, the dealer who had agreed to buy at $85 will lose and therefore, he might be tempted to dishonour the obligation. Futures were devised to guard against this contingency. These are booked always through an exchange (two of the oldest are the Chicago Mercantile Exchange and the Chicago Board of Trade) and both parties to the contract are required to pay/receive margins sufficient to cover the loss/profit, on a daily basis. In the above example, if the future contract is for $85 and the price was $80 when the contract was concluded, the party agreeing to buy should immediately pay the difference of $5. This margin will be adjusted daily (called marked to market) till the contract is completed. Futures are for fixed amounts and for fixed dates of completion, whereas forwards can be for odd amounts and for any period. These two are quite familiar to foreign exchange dealers. From commodities, these were adopted for currencies by importers and exporters whose profits depend, inter alia, upon the value of various hard currencies.

Options

Options enable one to "have the cake and eat it too.'' These are common in stock markets. For example, if a broker buys shares of a company at Rs. 250 per share and intends to sell them after three months at a profit, he can enter into an option contract for sale at Rs. 270 after three months. He has the option to sell at Rs. 270 but he is not obliged to exercise the option.

If the then ruling price is Rs. 240 he can exercise the option and make a profit; if, however, it is Rs. 300, he need not use the option. For this right, he has to pay the dealer (who writes the option) a premium or fee. While the buyer of the option has all the rights and no obligation, the option writer has only obligations. If the price were just Rs. 100 after three months, he would lose a substantial amount. Therefore, the premium is calculated in such a manner as to ensure that the losses of option writer are minimised, if not eliminated. Lot of esoteric arithmetic is used in fixing the premium.

Swaps in currencies/

interest rates

Swaps could be in currency or interest rates. When a U.S. company has a subsidiary in Germany and a German company its subsidiary in the U.S., the two can raise funds in their home countries at fairly reasonable rates but will not be able to do so in the country where their subsidiaries are located. By raising funds in their respective home currencies and exchanging the funds between them (dollar from the U.S. company for euro from the German company), both will benefit.

Interest rate swaps work in a similar manner. For example, a leading Indian company can raise a five year dollar loan from a London banker at a low floating interest rate, that is, one that rises and falls with the London inter Bank Rate. And, a medium sized U.S. company could raise the same loan at a low fixed rate in the bond markets. By swapping the two interest rates between them companies, both companies could gain. What happens is that the relative strengths of the two companies in different markets are exploited for common benefit (in a way, arbitraging on interest).

All these instruments initially evolved mainly to protect traders, bankers and others to hedge, that is, to protect against any adverse changes in prices affecting profitability. But over the years, hedging led to speculation and then degenerated into gambling. The leading example is the Long Term Capital Management (LTCM), a hedge fund in the U.S. The LTCM collected large funds from rich investors and rose like a meteor in the financial firmament. It adopted "scientific'' methods of gambling and employed a few Nobel laureates and many Ph D graduates. They tracked the past movements of interest rates and currencies and took huge bets on these rates. When the Russian economy faced enormous financial problems in 1997-98, all the calculations of the financial wizards went awry. The LTCM reportedly lost $4 billion in the fourth year of its existence and virtually wound up. The venerable Barings Bank of the U.K. was brought down by one young dealer Nick Leeson, who took heavy bets in derivatives.

In using financial derivatives, banks have to fully understand the magnitude of risks; otherwise they could face huge losses. Even central banks of various countries are concerned that banks may be taking undue risks in derivatives. To add to the problem, the total amount of derivative contracts, other than futures, entered into by any bank is not known to the central banks,

The latest form of derivative is credit derivatives. These, in the elementary form, are guarantees for loans granted by banks and financial institutions. They come in various shapes and garbs. Mr. Greenspan had referred to these when he said that the risk of financial debacle in the dotcom bubble was spread over many banks and institutions, thereby vastly mitigating the impact on the whole system. In India these are yet to be introduced.

Derivatives can be highly complex contracts and used with little or no knowledge of the implications, can prove extremely destructive. Highly complex instruments, either combining two derivatives or leveraging, namely, having a multiplier effect are introduced in the advanced financial markets, because there the banks and institutions make very little income from loans and have to develop esoteric products to earn profits.

Another ethical dimension is that in derivatives, banks earn only if the customer loses and vice versa. On the contrary, in lending money, banks' prosperity is entirely dependent on the customer's well being.

Thus, there could be a temptation to sell sophisticated derivative products by banks where the bank might be aware that the customer is taking undue risks.

In fact, many leading investment banks in the U.S. had to pay hefty fines to the authorities for alleged wrong advice to customers in derivatives. Indian banks and financial institutions would be well advised to be wary while taking to these products till they build up enough expertise to understand, appreciate and use them without burning themselves in the bargain.

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