Last full month, the headlines were dominated by two topics involving the financial sector – the farm loan waivers and the fall out of the sub-prime crisis. Incidentally, while one involves the Indian banking sector, the other involves the global investment banking industry.

While one similarity is as mentioned above, there are other parallels between the two episodes. At the same time, there are many differences also. Both the episodes involve loans of poor quality – granted for different reasons. Both involve relief package – while one arose out of the inability of a certain section of the society, the other was purely out of the greed of some. And while the stocks of Indian banks were hammered by the FIIs after the announcement of the loan waiver package by the Finance Minister, some of the same investors are looking up to the US Federal Reserve to announce a relief package to bail them out of their own deeds.

One perspective to these two stories involves the use of derivatives. In case of Indian farmers, they could hedge their positions through commodity derivatives. Due to lack of knowledge, understanding, availability – whatever the reasons – they did not use the same. Derivatives could have helped them against bad crop and worked as insurance. On the other hand, many of the investment banks used the derivatives they themselves had created to make huge profits in the past. The tide turned and the calls went wrong resulting into huge losses for many banks.

Let us discuss this further. Many of the derivative positions are not known to outsiders through the balance sheets as most of the positions are classified as “Off-balance sheet” items. ICAI has recently recommended that as a prudent practice, the companies should disclose their derivative position in the balance sheet so that the investors can take an informed decision.

It is not surprising that some learned investors equate the derivatives with dynamite. Dynamite was invented for the purpose of mining and look at its popular use at present. Derivatives could have helped the farmers if they used these contracts for hedging. On the other hand, when the financial institutions and some companies used these contracts as part of their treasury operations, the derivatives worked as weapons of mass destruction.

Any financial instrument is invented for certain purpose. In case of derivatives, the main objective of the contract is hedging for someone in need of certainty. Need of certainty is nothing but reduction in risk. If both parties have exactly opposite requirements and they enter into derivatives contract to safeguard their own positions: that is the best situation. However, it is difficult to find such situations. Hence, the financial intermediaries like banks work as market makers. They try and enter into two similar contracts simultaneously, so that they serve the needs of the clients and at the same time, they safeguard their own position also. Now, this is an ideal situation and such ideal situations do not exist in real life. Hence, the banks start doing two things – they charge extra fees (over and above that for facilitating) for their positions to compensate for the risk of open positions. (Open positions are those where the bank does not have a corresponding opposite position.) Secondly, they start taking a view on the contract.

Let us explain this through an example of a software services company. It is offering software off-shoring services to companies in the US. As the company is based in India, the major expenses, office rentals, staff salary and several other such expenses are paid in Indian Rupees. As against this, the income is in US Dollars. As long as the US Dollar is strong against Indian Rupee, i.e. rising, the company continues to be in a better position. However, the moment US Dollar starts weakening against Indian Rupee the company has the expenses growing faster than the income. In such a situation, the profit margins come under pressure. If the company anticipates adverse exchange rate movements, it has an option to hedge against such adversities. The company can approach a bank, which can help out through currency swapping derivative. The derivative is structured in such a way that even if the exchange rate moves against the interests of the company, there is a shield available as the rate has been fixed in advance with the bank through the derivative transaction. However, if the exchange rate moves favourably, the company would not get the benefit as it has foregone the same.

Now, the bank has an option of approaching an importer from the US, who buys products (or services) from the US market by paying US Dollar and sells the same in Indian market, earning in Indian Rupees. This company’s position is exactly opposite to the software company we discussed above.

The bank can enter into a contract with this importing company such that its own position is exactly opposite to that entered into with the software company. The bank is not neutral to the risk of currency fluctuation.
 
However, as mentioned earlier, banks may not get exactly same clients with opposite requirements. Often, some companies also take a view on the currency movement to decide whether to hedge the position or not. Add to that, the bank’s treasury operations may take a view on the currency movement and build positions to take advantage of the same. Many of the positions are not bad in themselves, but when the view is very strong and greed takes over, prudence takes backseat. Banks start taking benefit of leveraging. That is exactly what Bear Stearns did. It had positions in multiple of its own funds in the derivatives markets. Such positions need to be supported through borrowing from the market. For some reason, if the call goes wrong, or if the liquidity is not available, the whole thing starts unwinding, leading to spiralling of losses.

What do we have to learn as individual investors out of these episodes? First lesson comes from the legendary Warren Buffett, “Invest within your circle of competence. It’s not how big the circle that counts, it’s how you define the parameters.” It is important to understand where we are investing and what the possible downsides are. Second, avoid leverage as long as possible, especially, when one is investing the proceeds of the same into a highly volatile asset. Third, derivatives are meant to be used for the purpose of reducing the risk of unwanted events. The same derivatives can also, if not handled properly, increase the risk infinitely.