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    Mini Case: Kikos and The South Korean Won

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    Minerva Education
    The document discusses South Korean exporters using complex currency hedging products called KiKos from banks during a period of won appreciation. When the global financial crisis caused the won to rapidly depreciate instead, the exporters incurred enormous losses via the KiKos' knock-in features. Hundreds of lawsuits ensued as exporters argued the banks had not adequately explained the risks, though rulings favored both sides. The case raises questions about bank responsibilities and lessons for firms using foreign exchange derivatives.

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    Mini Case: Kikos and The South Korean Won

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    Minerva Education
    140 views9 pages
    The document discusses South Korean exporters using complex currency hedging products called KiKos from banks during a period of won appreciation. When the global financial crisis caused the won to rapidly depreciate instead, the exporters incurred enormous losses via the KiKos' knock-in features. Hundreds of lawsuits ensued as exporters argued the banks had not adequately explained the risks, though rulings favored both sides. The case raises questions about bank responsibilities and lessons for firms using foreign exchange derivatives.

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    MC07_Eiteman_85652_14_MC07

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    The document discusses South Korean exporters using complex currency hedging products called KiKos from banks during a period of won appreciation. When the global financial crisis caused the won to rapidly depreciate instead, the exporters incurred enormous losses via the KiKos' knock-in features. Hundreds of lawsuits ensued as exporters argued the banks had not adequately explained the risks, though rulings favored both sides. The case raises questions about bank responsibilities and lessons for firms using foreign exchange derivatives.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    140 views9 pages

    Mini Case: Kikos and The South Korean Won

    Uploaded by

    Minerva Education
    The document discusses South Korean exporters using complex currency hedging products called KiKos from banks during a period of won appreciation. When the global financial crisis caused the won to rapidly depreciate instead, the exporters incurred enormous losses via the KiKos' knock-in features. Hundreds of lawsuits ensued as exporters argued the banks had not adequately explained the risks, though rulings favored both sides. The case raises questions about bank responsibilities and lessons for firms using foreign exchange derivatives.

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    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 9

    Chapter 7

    Mini Case

    KiKos and the


    South Korean
    Won
    Mini-Case: KiKos and the South
    Korean Won

    That possibility arises from a


    fundamental tenet of international law
    that is not written down in any law book:
    In extremis, the locals win.
    —“Bad Trades, Except in Korea,” by Floyd
    Norris, The New York Times, April 2, 2009

    7-2 © 2017 Pearson Education, Ltd. All rights reserved.


    KiKos and the South Korean Won

    • South Korean exporters in 2006, 2007, and into 2008 were not particularly happy with
    exchange rate trends.
    • The South Korean won (KRW) had been appreciating, slowly but steadily, for years
    against the U.S. dollar. This was a major problem for Korean manufacturers, as much
    of their sales was exports to buyers paying in U.S. dollars.
    • As the dollar continued to weaken, each dollar resulted in fewer and fewer Korean won
    —and nearly all of their costs were in Korean won.
    • Korean banks, in an effort to service these hedging needs, became the sale and
    promotion of Knock-In Knock-Out option agreements (KiKos).
    • Many South Korean manufacturers had suffered falling margins on sales for years.
    Already operating in highly competitive markets, the appreciation of the won had cut
    further and further into their margins after currency settlement. As seen in Exhibit A,
    the won had traded in a narrow range for years. But that was little comfort as the
    difference between KRW1,000 and KRW 930 to the dollar was a big chunk of margin.
    • South Korean banks had started promoting KiKos as a way of managing this currency
    risk. The Knock-In Knock-Out (KiKo) was a complex option structure, which combined
    the sale of call options on the KRW (the knock-in component) and the purchase of put
    options on the USD (the knock-out component).
    • These structures then established the trading range seen in Exhibit A that the banks
    and exporters believed that the won would stay within. In one case the bank salesman
    told a Korean manufacturer “we are 99% sure that the Korean won will continue to
    stay within this trading range for the year.”

    7-3 © 2017 Pearson Education, Ltd. All rights reserved.


    Exhibit A South Korean Won’s
    Steady Appreciation

    7-4 © 2017 Pearson Education, Ltd. All rights reserved.


    KiKos and the South Korean Won

    • But that was not the entirety of the KiKo structure. The bottom of the range,
    essentially a protective put on the dollar, assured the exporter of being able to sell
    dollars at a set rate if the won did indeed continue to appreciate.
    • This strike rate was set close-in to the current market and was therefore quite
    expensive. In order to finance that purchase the sale of calls on the knock-in rate was
    a multiple (sometimes call the turbo feature) meaning that the exporter sold call
    options on a multiple, sometimes two or three times, the amount of the currency
    exposure. The exporters were “over-hedged.”
    • This multiple yielded higher earnings on the call options that financed the purchased
    puts and provided added funds to be contributed to the final KiKo feature.
    – This final feature was that the KiKo assured the exporter a single “better-than-market-rate” on the
    exchange of dollars for won as long as the exchange rate stayed within the bounds.
    – Thus, the combined structure allowed the South Korean exporters to continue to exchange dollars for won
    at a rate like KRW 980 = USD when the spot market rate might have only been KRW 910.
    • This was not, however, a “locked-in rate.” The exchange rate had to stay within the
    upper and lower bounds to reap the higher “guaranteed” exchange rate.
    – If the spot rate moved dramatically below the knock-out rate, the knockout feature would cancel the
    agreement. This was particularly troublesome because this was the very range in which the exporters
    needed protection.
    – On the upper side, the knock-in feature, if the spot rate moved above the knock-in rate the exporter was
    required to deliver the dollars to the bank at that specific rate, although movement in this direction was
    actually in the exporter’s favor. And the potential costs of the knock-in position were essentially unlimited,
    as a multiple of the exposure had been sold, putting the exporter into a purely speculative position.

    7-5 © 2017 Pearson Education, Ltd. All rights reserved.


    Exhibit B South Korean Won’s Fall
    and the Knock-In

    7-6 © 2017 Pearson Education, Ltd. All rights reserved.


    KiKos and the South Korean Won

    2008 and Financial Crisis


    • It did not take long for everything to go amiss. In the spring of 2008 the
    won started falling—rapidly—against the U.S. dollar. As illustrated by
    Exhibit B, the spot exchange rate of the won blew through the typical
    upper knock-in rate boundary quickly. By March of 2008 the won was
    trading at over KRW 1,000 to the dollar. The knock-in call options sold
    were exercised against the Korean manufacturers.
    • Losses were enormous. By the end of August, days before the financial
    crisis broke in the United States, it was estimated there were already
    more than KRW 1.7 trillion (USD 1.67 billion) in losses by Korean
    exporters.
    Caveat Emptor (Buyer Beware)
    • The magnitude of losses quickly resulted in the filing of hundreds of
    lawsuits in Korean courts. Korean manufacturers who had purchased
    the KiKos sued the Korean banks to avoid the payment of losses, losses
    that in many cases would cause the bankruptcy of their businesses.
    • Exporters argued that the Korean banks had sold them complex
    products, which they did not understand.

    7-7 © 2017 Pearson Education, Ltd. All rights reserved.


    KiKos and the South Korean Won

    • The lack of understanding was on at least two different levels.


    • First, many of the KiKo contracts were only in English, and many Korean buyers did not
    understand English.
    – The reason they were in English was that the KiKos were not originally constructed by the Korean banks.
    – They were created by a number of major Western hedge funds that then sold the products through the Korean
    banks, the Korean banks earning more and more fees for selling more and more KiKos.
    – The Korean banks, however, were responsible for payment on the KiKos; if the exporting companies did not or
    could not pay-up, the banks would have to pay.
    • Secondly, exporters argued that the risks associated with the KiKos, particularly the knock-in
    risks of multiple notional principals to the underlying exposures, were not adequately explained
    to them.
    – The exporters argued that the Korean banks had a duty to adequately explain to them the risks—and even more
    importantly— only sell them products that were suitable for their needs. (Under U.S. law this would be termed a
    fiduciary responsibility.)
    – The Korean banks argued that they had no such specific duty, and regardless, they had explained the risks
    sufficiently. The banks also argued that this was not a case of an unsophisticated buyer not understanding a
    complex product; both buyer and seller were sufficiently sophisticated to understand the intricate workings and
    risks of these structures. The banks had in fact explained in significant detail how the exporters could close-out
    their positions and then limit the losses, but the exporters had chosen not to do so.
    • In the end the Korean courts found in favor of the exporters in some cases, in favor of the banks
    in others.
    – One principle that the courts followed was that the exporters found themselves in “changed circumstances” in which
    the change in the spot exchange rate was unforeseeable, and the losses resulting—too great. But some firms, for
    example GM Daewoo, lost $1.11 billion.
    • Some Korean banks suffered significant losses as well, and may have in fact helped transmit the
    financial crisis of 2008 from the United States and the European Union to many of the world’s
    emerging markets.

    7-8 © 2017 Pearson Education, Ltd. All rights reserved.


    KiKos and the South Korean
    Won: Case/Discussion Questions
    1. What were the expectations—and the fears—of the
    South Korean exporting firms that purchase the KiKos?
    2. What is the responsibility of a bank that is offering and
    promoting these derivative products to its customers?
    Does it have some duty to protect their interests? Who
    do you think was at fault in this case?
    3. If you were a consultant advising firms on their use of
    foreign currency derivative products, what lessons
    would you draw from this case, and how would you
    communicate that to your clients?

    7-9 © 2017 Pearson Education, Ltd. All rights reserved.

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