It’s not just IRS: the embedded lawsuit option in FX options

Walter Kurtz at Sober Look had a great piece a few weeks ago, where he wryly suggested a way to make money if you don’t like that IRS the bank’s sold you: default on the payments and sue the bank. (Note: this is not an actual way to make money, and also not a good idea if you don’t like angry traders hunting you down.) 

The “sue the bank” option has a long and storied history in corporate hedging circles. Pick up a copy of Satyajit Das’s Traders, Guns and Money, and right there in the first chapter is an Asian-Crisis-era story of an Indonesian noodle maker defaulting on a massive IRS liability. Even further back, in 1988, the Hammersmith and Fulham local government decided they could make free money by selling sterling swaptions and pocketing the premium; as soon as rates went against them, they sued. 

This trend broke through into FX options in a very big way in 2008. 

In 2006 and 2007, Korean corporates latched on to a new craze in FX hedging – the KIKO (knock-in/knock-out) option. 

A corporate – generally a corporate custy that needed to sell USD against KRW – would trade a strip of these KIKOs, structured so that the corporate would pay zero for the hedge, or even receive a nominal amount upfront. If USDKRW went down, the option would knock out, and the corp would be left with a small gain; if USDKRW went up, the corp would be locked in to selling at an unfavourable rate.

Now if you think about this a bit, you’ll see why this is a bloody terrible trade. 

If USDKRW goes down, their protection gets knocked out, and they end up having to sell USD at a lower price than where they started. If USDKRW goes up, as it tends to do during panics, the customer gets knocked in, and they get stuck with a contract that forces them to sell large amounts of USDKRW at an unfavourable rate. 

Now there was a reward for all this unfavourable risk, and that reward was cold hard cash – KIKOs were usually structured to reward the corporates with cash gains, and if USDKRW drifted lower or stayed where it was, they’d get to pocket that cash. 

But in 2008, USDKRW exploded from 900 to 1600 – leaving corporates stuck selling USDKRW at a 40% discount to the current price, and no amount of upfront premium can fix a loss like that. This Bloomberg story profiles one company that got caught on a set of KIKO contracts… and they went bankrupt. Hundreds of other companies sued Korean banks. 

The eventual finding seems to have been that most of the KIKO contracts were valid – but that finding came at the cost for the banks of two years of litigation. Here’s Kim & Chang, the firm that represented some of the financial institutions in the KIKO lawsuits:

 In connection with a recent German Supreme Court precedent, in which the court held that financial institutions were obligated to (i) explain to customers the negative market value of interest rate swap products and (ii) educate purchasers on interest rate swap products so that customers could learn as much about the products as the financial institutions, the Court commented that such a ruling should be limited to cases where the consulting contracts have been executed between the financial institutions and purchasers. Accordingly, and given the speculative nature of interest rate swap products, the Court held that the German Supreme Court’s holding does not apply to the present case.

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I tend to think that corporates have no business trading exotic FX options, mostly because exotics are not a good hedge for the vast majority of corporate FX risks – but also because the litigation risk if the trade goes pear-shaped is a guaranteed headache for both sides. 

(In theory, smart corporates would only ever buy options – that way they get all the upside, none of the downside, the bank takes none of the litigation risk, and the customer gets favourable hedge accounting treatment under IAS39. Google, for example, understands this very well; Numerix, in its analysis of Google’s hedge book, doesn’t. Partial barrier forwards? Seriously?)

Coming up soon – an application of the embedded lawsuit option to Liborgate, and why I was wrong about the lawsuit risks the Libor banks face. 

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