A V Rajwade: Hedging, speculation and derivatives

Having analysed, in recent months, a couple of hundred currency derivatives transactions involving 30-odd companies, one is equally struck by the corporate governance weaknesses which the incidents highlight and the interpretation of the concept of hedging, and the credit risk exposures arising therefrom, on the part of the banking system.

Even before the recent problems and losses in currency derivatives, there were question marks about some of the banks' clarity on the definition of hedging. Some nationalised banks, which had issued fixed interest rate, long-term bonds to augment their Tier II capital, had swapped (i.e. exchanged) the coupons for JPY LIBOR-based interest in the Japanese currency, calling them as hedges. Others, more conservative, swapped the fixed rate coupons into floating rate. The objective obviously was to reduce costs: but can the transactions be considered as hedges? In fact, the bonds had no price risk which could be, or needed to be, hedged: the coupon was fixed and there was no interest-fluctuation risk. Similarly, the issued bonds are not marked- to-market in the books of the issuer and, therefore, there was no fair value risk either. The coupons may be high in relation to the ruling interest rates and may therefore be uneconomic