Recently I
picked up this book ‘Traders Guns and Money’ by Satyajit Das. The book highlighted
some of the common misplaced notions of how risk management products instead of
hedging risks can in fact double the losses if used in a detrimental fashion. The
book begins with a very hilarious encounter about OCM, a noodle maker from
Thailand which finds itself embroiled in the mysterious web of derivates, and
deals that it undertook that would serve as a final nail in the coffin for the
company.
I wanted to
outline some of the deals in a chronological order so that it gave me a
perspective on how some of these potent products can harm innocent customers,
who get committed to these deals without knowing the mess they are getting into.
Following is a rendition from the book
which i highly recommend to like minded folks who are curios about the way the
derivative world works.
1) OCM enters into a common currency SWAP that allows it to pay dealer
dollar rate LIBOR as part of its interest and principal payments of the
borrowing while the dealer pays the counterpart in Thai rupiah. This arrangement
of a swap agreement allows for cheaper borrowing for the counterparty and the
dealer.
2)
When the dollar yield curve was steep, the company entered into a ‘Arrears
Reset SWAP’ in which the interest rate is reset on a 6 months basis, with
payments to be made 2 days before the reset. As the dollar interest rates began
to rise, the dealers advised to get out of the transaction and have the OCM
make some profit.
3)
With some conviction that the rate would keep increasing, the dealers
asked OCM to enter into a transaction that would allow them to fix the rates.
This allowed OCM to make some more money.
4)
With confidence over the transactions, OCM were lured by the success of
their financial genius by now entering into a ‘Double SWAP’. This was the transaction
that led to their grave.
The dollar rates at
this time were steep i.e. the 5 yr rate was higher than the 6 month rate. OCM
now entered into a contract to have the interest rate fixed for five years. This
meant the cost of borrowing would be high but not necessarily higher than the
rupiah rates.
To make the cost
cheaper, OCM decided to place a bet, wherein if the rates increased then the
fixed rate would convert into floating and if the rates went down the deal
would double the size i.e. if they were to pay $300 now they pay $600. This
meant, with the new swap, if the rates went up then their protection of fixed
interest rate would be lost as it converted into floating rate and if it went
down then the size of the transaction doubled. Mmmm...something fishy ? On top
of that there was a exchange rate risk. If the dollar appreciated (rupiah
weakens) then it would haven really cumbersome. However if the dollar weakened
(rupiah appreciated) OCM would not incur exchange risk on the $600 but on the original
$300 of the transaction as that was at a fixed exchange rate. This is probably their
death knell move.
OCM had entered into these trades to lower the cost of borrowing by
entering into fixed dollar rate. OCM achieved the lower cost by selling lots of
its options (on dollar interest rates and rupiah/dollar exchange rate) to the
dealer.
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