Exotic Entrapment!

Why did so many companies enter into exotic products without understanding? The answer is greed.

May 03, 2010 2:23 IST | India Infoline News Service

I recently met a SME promoter, and during the routine projections slide, happened to see a line item – forex losses. The usual round of discussions followed led by a standard question – why a small domestic company, with zero forex exposure, both on sales and on expenses side, traded derivatives? The first generation promoter, with tons of retail selling experience, attributed it to the persistent sales efforts and wonderful sales pitch of the bank relationship manager. His CA advisor added the standard lines – bank has cheated  us, we should not have paid up, we should take them to court, etc. 


The promoter, to his credit, simply acknowledged his  mistake and said that it was a good learning experience. He also added in small voice that for 2-3 quarters they booked some forex gains, but in the ultimate analysis lost money because of adverse rate movements.

Why did so many companies enter into exotic products without understanding? The answer is greed. You were shown a number of slides of historic price movements of currencies which pointed out that if you do the trade, you will make money on forex gains or your interest expense will come down.  In good times people do get carried away and don’t read fine print. They don’t ask questions and get carried away with the flow and complain when the tide turns. Caveat emptor principle works in financial services also. No sales person in any profession is going to point out all the negatives, unless you ask.


It is like going to a job interview and when asked what your weaknesses are, reply that “I am a perfectionist, I set very high standards for my self, I am very quality conscious and that stresses me and so on”. Has anyone answered that “I am not good with numbers, I am a brilliant individual performer but a pathetic team player, I do not know Power Point”.


The last one, incidentally is one of my many weaknesses and I get maha impressed with the younger generation who make very nice Power Point presentations with 3D shapes and arrows.

Before buying any product, you must ask at least this one question – what is the worst case scenario and what is the probability of the event occurring? In the unlikely event of the worst case scenario materializing, are you in a position to take the hit? Will you survive or go down under? If the answer is no, then the risk is simply not worth it. Simply treat the banker to some nice tea and biscuits and send him away. After that, do not get jealous seeing others making money on the exotic instrument because they took a risk which you could not have afforded.

One must also know that what has never happened in twenty years can happen in the next twenty minutes. I will narrate an anecdote, told to me by my analyst friend, that brings home this point. In the sidelines of an analyst meet, the CFO of a large corporation was being grilled about forex losses. Tired after politely answering all questions, he took some analysts aside and confessed his mistake. He said his mistake was to buy the currency after seeing historic 20-year data. It was just like seeing a 20-year unmarried male in India and concluding that the person will never get married. The real dialogues were in Hindi and much more colorful.

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