Currency derivatives and corporate losses: this time is different?

BIS Quarterly Review  |  September 2014  | 
14 September 2014

(Extract from page 43 of BIS Quarterly Review, September 2014)

The Lehman bankruptcy in September 2008 triggered a global shortage of US dollar funding, lifting the US currency. According to one estimate, the ensuing sharp depreciation of local currencies against the dollar hit 50,000 or more non-financial corporations with total losses of at least $30 billion, via positions on foreign exchange (FX) derivatives contracts.image This added to the uncertainty in those corporates' domestic financial markets, worsening the impact of the crisis still further. Given that many EME corporations are said to have increased their foreign exchange exposures significantly in recent years, a key question is how vulnerable such firms are to, possibly abrupt, exchange rate movements. This box reviews some key features of the derivatives activities of EME corporations in 2008, and highlights differences between then and now.

One factor behind EME corporates' foreign exchange losses in 2008 was the popularity of contracts with a "knock-in, knock-out" (KIKO) feature. Heavy use of such contracts meant that many exporters, while insured against modest exchange rate movements, were exposed to possibly large losses if the local currency depreciated sharply.

In a standard FX option transaction, a company (eg an exporter) with revenues mostly in foreign currency (eg in US dollars) but with production costs in local currency buys, for a small fee (premium), a put option from a counterparty (eg a local bank) that gives the exporter the right but not the obligation to sell its dollar income at a specific strike price at a future time. If the domestic currency spot exchange rate at maturity is stronger than the agreed rate, the exporter exercises the option and gets a higher income in local currency terms than it would otherwise get at the spot rate.

Compared with this basic setup, KIKO contracts have two additional features. The first is a call option (knock-in) held by the bank. If the reference currency (eg the US dollar) strengthens beyond a certain threshold, the knock-in requires the exporter to sell its dollars at the strike price (ie below market rates). The second, so-called knock-out, feature dictates that no option can be exercised by either the exporter or the bank if the dollar weakens below a certain threshold. Both features serve to reduce hedging expenses, albeit at the cost of retaining the tail risk of stronger currency depreciations.

A third feature is possible acceleration effects. KIKO contracts were quite often leveraged (at, say, 1:2), resulting in payments that would double the contractual amounts. This resulted in open speculative positions on relatively stable exchange rates. Furthermore, some EME corporations apparently purchased multiple KIKO contracts with different banks to bypass each individual bank's counterparty limit. As a result, when the US dollar rose sharply against almost all currencies in late 2008, these corporations suffered "unexpected" losses owing to the knock-in feature in their hedging operations.

Given the risk of high potential losses, a key question is why so many EME corporations used KIKO or similar contracts to hedge their FX exposures prior to 2008. There are a number of possible explanations. By design, KIKO features lower the premium charged by the contract seller. In that sense, many EME corporations were attracted by the low hedging costs. This feature was particularly attractive at the time, as the major EME currencies had experienced a long period of slow but steady appreciation against the US dollar. The resulting false sense of security was reinforced by most commercial and official forecasts, which, up until 2007, called for this trend to continue in the near term. Furthermore, local banks were often not the actual seller of the KIKO contracts, but merely acted as intermediaries for foreign banks and ultimate investors, such as hedge funds. In doing so, banks earned a fee while passing the exchange rate risk on to the ultimate contract sellers. Under such circumstances, banks may have had an incentive to sell more contracts to increase their fee income, at least insofar as their client relationships with their corporate customers were not jeopardised by any losses that their clients might incur.

Against this background, an important difference between now and then is that the recent prolonged period of relatively low volatility in foreign exchange markets has been punctuated by the two "tapering" events, in May 2013 and January/February 2014. No major losses from corporate exposures in derivatives markets were revealed in the aftermath of these episodes. That said, carry trade incentives have since strengthened again, and certain EME corporations may have incurred exposures via contracts that will generate losses only at a later stage. For example, there is anecdotal evidence of increased interest from Asian corporates in structured foreign exchange products with KIKO-like features. In addition, for some EME hedging markets, the sellers of hedging products are often concentrated and the markets themselves are not very liquid. Again, this tendency could exacerbate any market reaction once the market changes direction.

image See eg Sidaoui et al (2010) and Lee (2009).