Are derivatives the panacea?

I came across this news in business standard which actually got me thinking. The snapshot of the news-item is:

Sundaram Multi Pap, a Mumbai-based paper stationery manufacturer, on Monday disowned exotic hedging contracts entered into with ICICI Bank, saying the bank had misled the company into taking derivatives positions much beyond their underlying export risks.

This is a classic case of fancy hedging structures, where exporters convert their dollar receivables into Swiss franc, which has begun to hurt exporters as the otherwise stable Swiss currency has appreciated against the weakening US currency.

The currency bets have gone wrong in many cases, so I am sure there must be many such cases. This has been reported so it spins many questions:

1) Can we forecast the currency movement? I think not. It is still very much a random-walk despite many models etc. on the same. A landmark paper by Rogoff et al in 1983 showed currency movement is random and still holds true. Read this superb article for details.

2) Issues in risk management: The companies have realised this and know there is 50% chance of getting things right. As a result we need to keep provisions etc for the negative 50% risks. In this case, I guess the risks were ignored and hence the losses.

3) Whose problem? ICICI Bank’s Puri-Buch said, “There is also an issue of precedence set in the market. As long as the market was doing well, companies reaped profits. Now that they are making losses, they want to renege on the transactions. Full disclosures are made to the clients.”

That is the problem. On hindsight, derivatives are still not understood by the best in the financial business. Still, they are sold and promoted as if it isn’t risky at all. The derivatives are for hedging but are like any other financial instrument- risky.

This brings me to a bigger problem. It is one thing to design derivative markets, it is altogether a different thing to sell them in a manner so that people understand the risks involved. A wrong position in derivatives can wipe out the entire capital in a second.

It also makes me recall stories related to ISO certifications. ISO -9001 was seen as a panacea for the Small companies in India. As it was an internationally accepted quality standard, any company which had the certificate had a much better chance to access foreign markets. In other words, it reduced the information asymmetry. The government even started providing incentives to small companies to get the ISO-9001 certificate.

However, some companies after getting the ISO certificate, appealed to take the certification back. Why? Managing ISO -9001 required a lot of effort continue to follow the processes and had costs as well. So the companies were not interested in the same anymore.

There is quite a bit of similarity in the two cases. The magnitude of losses may differ but problems are quite similar.

By simply saying that the rupee should be left to markets and one should develop currency derivative markets for exporters to hedge their risks, is not a good enough solution. A lot more needs to be done.

2 Responses to “Are derivatives the panacea?”

  1. First ICICI Bank, then L&T, what is next? « Mostly Economics Says:

    […] had pointed this long back when it was reported that one of ICICI Bank’s customers had complained that […]

  2. panacea Says:

    The 700 billion dollar US financial bailout package is

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