When a hedge is not a hedge

Citic Pacific's $2 billion loss was characterised as a currency hedge, but if that was really its intention it had quite the opposite effect.
Leslie Chang must have buried his head in his hands on more than a few occasions during the past few months. Before the summer, Citic Pacific's finance chief had been quietly profiting from the Aussie dollar's gentle rise against the US dollar, but his satisfaction turned to horror in July when the foreign exchange market turned suddenly and severely against him.

Thanks to a series of highly leveraged FX bets that he made, Chang, who resigned on Monday, committed Citic Pacific to buying the Aussie dollar at $0.87 even as its value collapsed to $0.65. Combined with similarly disastrous bets on the euro, Chang's trades were $1.9 billion in the red at Monday's market prices and have already cost the company $104 million on contracts that it has closed out.

Citic Pacific says that Chang and his team placed the bets "with a view to minimising [the] currency exposure of the company's iron ore mining project in Australia", which makes it sound as though the trades were supposed to be currency hedges.

But the same announcement goes on to say that the contracts "do not qualify for hedge accounting", which explains why the company was forced to reveal the mark-to-market losses to shareholders û hedge accounting allows companies to offset some of the mark-to-market volatility of derivatives instruments if it can show that the trades are being used to counter currency fluctuations in its cash flows.

Clearly, Citic Pacific's trades did not meet this standard û and no wonder. The instruments are, in effect, FX versions of the equity accumulators that burned so many retail investors in Hong Kong earlier this year. Under the target redemption notes that account for most of the losses, Citic Pacific is committed to keep buying Aussie dollars at $0.87 until October 2010, but, significantly, the potential downside is unlimited while the upside is capped, typically at 10% of the notional value.

Chang was doing fine when the Aussie dollar was up at $0.98 in mid-July, but that 25-year high did not last long. As its value has plummeted, Citic Pacific's hedge has become a huge liability.

Henry Fan, Citic Pacific's managing director, has been quoted as saying: "I was shocked. I asked Leslie how could this happen, and he said he omitted to assess the downside risk."

That much is obvious, but it once again raises the question of the appropriateness of sophisticated investment banks selling complex products û or toxic derivatives, as some like to call them û to businesses that are not well-equipped to understand them.

A chief financial officer at another large Asian conglomerate says that investment bankers had been aggressively pushing these products as clever hedging tools when the US dollar was weak. "But this stuff is not for novices," he says. "Most CFOs are not trained for analysing these products and as a result a lot of corporates rely on banks to provide them with real solutions, rather than just taking advantage of them."

Compared to Citic Pacific, this CFO was relatively lucky û he says that one of his subsidiaries lost about $30 million to a very similar FX trade, which he describes as having "uneven" payoffs. "Once you generate, say, $1 million of profit, the whole contract knocks out," he says. "But if the contract is losing, there is no way the whole transaction knocks out. Given a reversing trend, this whole thing can exponentially multiply. It's not the simple, highly liquid, very transparent hedging product you will normally see in the market."

Some bankers agree, up to a point. "Whether you can call these hedging instruments is open to interpretation," says one FX specialist. "It all depends on the underlying cashflow as to whether they suit this purpose or not. By the same token, it is also open to interpretation whether they are toxic or not. At least the structure is quite simple û it can be explained in a very simple way and you can clearly see how and when you will make money and how you will lose money."

The problem with buying plain vanilla options as a hedge against uncertain cashflows, he says, is that the company is buying volatility, which means paying an up-front premium. "That may not be everyone's cup of tea," he says, which led some companies to consider hedging products with cheaper up-front costs, through selling volatility.

Having done just that, Citic Pacific now finds itself in a tricky position û to unwind its positions, it faces the daunting task of buying volatility at today's hugely inflated premiums. A trader might favour taking a view and trading his way out of the problem, but Citic Pacific probably does not have much stomach for risking further losses. Its share price has been beaten down to HK$5.92 from last week's close of HK$14.52 û a drop of almost 60%. In February, it peaked at close to HK$43.

To make matters worse, Hong Kong's securities regulator has now launched a formal investigation into Citic Pacific. So far, neither the company nor the Securities and Futures Commission has said what the investigation is about û though the company's shoddy disclosure and vague management structure is certainly a concern.

However, some CFOs argue that regulators should be turning their attention to the investment banks: "The issue here is the appropriateness test," says one.
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