Hoax hedges

When Citic Pacific admitted it is likely to lose nearly $2 billion from currency 'hedges' that were much larger in scale than its underlying exposures, it highlighted a practice that has spread to much of Asia. By Kathleen Kearney

Currency volatility in the third quarter of the year is causing problems for a range of corporates in Asia. But some parties have suffered substantial losses from so-called currency 'hedges' far larger than their underlying exposures. The most prominent case to date is that of Citic Pacific. The Hong Kong-listed conglomerate says it is facing potential losses of nearly $2 billion - an amount equal to about one-quarter of its net assets - when it issued a profit warning in mid-October related to so-called 'over-hedging'.

While Citic Pacific's losses caught attention because of their sheer scale, the company was not the only one in the region over-hedging. In South Korea, the situation is so extreme that dozens of exporters may go bankrupt. About 100 smaller South Korean companies filed a class-action lawsuit against more than a dozen banks - including Citi, HSBC and Standard Chartered, as well as several local banks - seeking to nullify currency deals that threaten to sink them. There have also been claims of mis-sold currency hedges in other countries, from India to Singapore.

The South Korean trades in question were primarily knock-in, knock-out contracts, where dollars were sold at a fixed rate as long as the won remained within a set range. But in late September, the won fell by as much as 30%, forcing companies to sell dollars below the market rate and so incurring losses that threatened their very existence.

Citic Pacific's losses are the most prominent by a single company so far, forecast to be almost four times the $550 million China Aviation Oil incurred on jet fuel trades in 2004 - previously the largest documented currency loss ever by a Chinese company (see Asia Risk, December 2004).

The Securities and Futures Commission (SFC), Hong Kong's markets watchdog, launched a formal investigation into Citic Pacific's affairs on October 22, it said in a statement, but would not answer questions regarding the investigation. Hong Kong Exchanges and Clearing, parent of the Stock Exchange of Hong Kong, is also examining the company's activities, as is the China Securities Regulatory Commission (CSRC), the markets watchdog in mainland China. The CSRC has no direct supervision over Citic Pacific, but it does over its Beijing-based parent, Citic Group.

Citic Pacific listed four types of contracts it says it held in relation to currency exposures from an iron ore mining project in Western Australia for which supplies were obtained using Australian dollars and euros, according to a filing with the Hong Kong stock exchange. The positions were taken "with a view to minimising the currency exposure", the company said in its statement. Others questioned whether this is an accurate description. Citic Pacific declined to comment for this article.

But the leveraged forex contracts did not qualify for hedge accounting, the company has disclosed, and therefore needed to be marked to market at the end of each financial period. According to the terms of the largest position - an Australian dollar target-redemption forward (Tarf) - the contract, initiated at an exchange rate of $0.85 to the Australian dollar, capped the return to the contract holder with a capped call on the Australian dollar at a weighted average strike price of $0.87. In another contract, Citic Pacific was required to buy euros at a weighted average strike price of $1.44.

None of the contracts did not include a similar knock-out feature for losses, thereby setting the company up for huge losses if the Australian dollar reversed its course. On October 21, the day after the company disclosed its holdings, the Australian dollar was trading at $0.698 and the euro at $1.3330. By October 20, the company had realised a loss of HK$807.7 million ($105 million) and estimated an additional loss of HK$14.7 billion on the outstanding contracts at mid-October exchange rates (see box).

Citic Pacific moved into the production of specialty steels a decade ago and has three large plants on China's east coast. In the past two years, the company has doubled its production capacity to more than 7 million tonnes. In 2006, to aid this expansion, the company acquired mining rights to 1 million tonnes of iron ore in Western Australia for A$1.6 billion ($1.12 billion). In 2007, the company took up an option to expand those rights to 2 million tonnes. It also separately contracted to buy 12 vessels to ship the ore to China. At the end of last year, the company had total net assets of HK$65 billion, a gearing level of 26% and HK$12 billion in cash balances. It looked to be an ideal blue-chip company.

Many of the company's senior management have been with the group for 15 to 20 years. According to its annual reports, Citic Pacific actively hedged its interest rate and foreign currency exposures and had well-established risk management procedures and hedging policies. "Risk management, including the employment of derivative contracts on both asset and liability management, was to be done at head-office level," said its 2007 annual report. At the same time, such exposures were "always kept to an acceptable level by entering into foreign currency forward contracts in the subsidiary companies level and they are usually matched with anticipated future cashflows in foreign currencies".

The same report shows Citic Pacific substantially expanded what it calls its hedging programme in that year. The notional principal amounts of the outstanding contracts on December 31 were HK$13.46 billion, compared with HK$6.26 billion at the end of 2006.

During 2007, the company increased its positions in those forward currency contracts, which can be classified as cashflow hedges, to HK$3.72 billion from HK$729 million at end-2006 and in forward forex contracts, which do not quality for hedge accounting, to HK$9.25 billion from HK$6.12 billion. The contracts ranged in tenor from less than one year to five years.

Citic Pacific appeared comfortable with the need to hedge its exposures and gave the following descriptions of its hedging needs in its 2007 annual report. On the asset side, its projected non-US dollar expenditures as at December 31, 2007 amounted to HK$2.659 billion hedged through "foreign exchange forward contracts" - compared to zero in 2006. And HK$882 million was hedged using "structured forward instruments", it said, but did not further describe further what kinds of instruments were being used.

As for liability management, Citic Pacific said it funded the iron ore mining project and the acquisition of vessels with US dollar loans to match the future cashflow of these assets. Forex forward contracts were used to minimise currency exposure for other dollar debts and a Japanese yen bond. As at December 31, such contracts outstanding amounted to HK$5.85 billion, as against HK$6.12 billion at the end of 2006. In addition, the trading subsidiary used forex forward contracts to hedge currency fluctuations; as at December 31, 2007, such contracts amounted to HK$707 million.

This big increase in forward forex contracts and hedging of assets appears to be in aid of the iron ore project coming on stream and exchange rate fluctuations during the year. But the charge of over-hedging appears a valid one, given the investment in the Australian mining rights of A$1.6 billion in 2007 and the maximum deliverable amount to Citic Pacific under all the Australian dollar Tarfs of A$9.05 billion. And Citic Pacific does not appear to have informed investors about any major changes to its policies in this area.

Chairman Larry Yung said in a statement that group finance director Leslie Chang Li-hsien failed to follow both the group's hedging policy and its set procedures to obtain the approval of the chairman before con- ducting the forex transactions. He also said group financial controller Chau Chi-yin "failed to bring to the attention of the chairman any unusual hedging transactions". Both have resigned.

Citic Pacific's hedging may have been excessive, but the basic strategy seems in line with practice at many companies. Many structurers of hedging solutions say a company should have a dual hedging strategy: the first, core hedging, done prudently and conservatively, using plain-vanilla currency forwards and similar products; and this should be 'topped up' with a second, tactical hedging strategy, using exotic structures to take advantages of changes in the market.

"Plain-vanilla instruments are almost always directional, whereas with exotics you can express a view," says a senior corporate sales executive at a US dealer. "With multi-faceted exotic instruments, a company will have a much more dynamic approach to its exposures and the outlook of the industries it is involved in, as compared to a static or passive hedging policy of set-and-forget using forward contracts." This may be especially useful with regard to a liability management strategy. "Someone who is employed to manage financial risk - the CFO or the treasurer - should have a view on the business and on the markets and should be able to express that with structures," says the salesman.

Black-box calculations

Citic Pacific could not have foreseen the sharp fall in the Australian dollar, nor the rise in volatility that the market jitters caused and thus could not have calculated the depths of its mistake. But it did put the company in jeopardy with these large forex contracts.

Every investment bank will employ its own parameters to price contracts, which they do not necessarily release to the buyer. So the implied volatility, which is used to price the option - in Citic Pacific's case, the put option - for the marking-to-market of Tarfs is done by the bank with its own inputs. For example, the mark-to-market value will be driven by factors such as the volatility, liquidity, bid-ask spread and interest rate differential at the time when such contracts are marked to market.

There is no way for the bank to give a potential indicative price for unwinding the contract in advance. "The client could dispute the pricing, since it depends on the trader's perception of the market, but he won't. He has to accept the price," says one structurer with a European bank in Hong Kong.

"You cannot get transparency on the terms in advance, because the investment bank doesn't know what the volatility in the market will be at the expiration or settlement date," he adds. When the market is moving in the client's favour, there tends to be no dispute about transparency in pricing, but "when it is going against your position, then there will be a lot of controversy", he adds.

Citic Pacific has not publicly disputed the settlement prices of its contracts. And it says it is working with the banks to restructure its contracts, but does not give further details.

Market participants believe the company took positions via accounts with eight different banks. This means bankers may not have had a clear view of the true size of their counterparty's positions. Derivatives counterparties would therefore base the size of the position the company had with them on the sizeable cash balances held by Citic Pacific. Following the July-to-September bout of extreme volatility and the number of corporate trading losses, bankers are considering changes in their practices.

That's a similar claim to the one dealers are making in South Korea, where they say they were unaware trades were being put on with multiple counterparties. A new database is now being mooted to allow financial institutions in South Korea to have a clearer picture of their true counterparty risks.

Meanwhile, there are expectations of a shake-up in practices elsewhere in Asia. "We are definitely going to change the way we do business, because we need to take a lot more care to understand how much our clients are hedged," says the US bank sales executive. "The banking industry is going to be a lot stricter about getting that information, because the banks don't want the clients to blow up, that's for sure."

This article was first published in Asia Risk, November 2008

CITIC PACIFIC'S WAYWARD 'HEDGES'

Citic Pacific used target-redemption forward (Tarf) contracts and daily-accrual contracts in a bid to 'hedge' its future Australian dollar, euro and renminbi liabilities. Australian dollar Tarfs have caused the main problems. They work by going long Australian dollars by selling a leveraged A$/US$ amount on the downside below-spot levels at execution time.

A Tarf is suitable for investors that have a short-to-medium-term bullish view - in this case, on the Australian dollar - and are willing to assume the risk of the Australian dollar depreciating against the US dollar over the life of the Tarf.

The Tarf auto-redeems if the investor's cumulative return reaches the target level, which helps lock in profits against a possible adverse move in A$/US$, something not expected until late in the life of the Tarf and after initially positive returns. Tarfs are usually priced at zero cost subject to the auto-redemption condition.

Tarfs comprise a strip of leveraged forwards with monthly expiries and with an auto-redemption feature linked to the cumulative positive return received by the investor. Usually, the investor receives one times (via one call) the upside of the Australian dollar, while being exposed to two times (via two puts) the downside of the Australian dollar, in return for more favourable strikes rates on the contract.

The Australian dollar Tarfs bought by Citic Pacific had a weighted average strike price of 0.870, and the maximum deliverable amount to the group for all its Australian dollar Tarf contracts was A$9.05 billion. The maximum notional accumulation under the renminbi Tarfs was 10.4 billion renminbi ($1.52 billion), payable in US dollars.

Citic Pacific also held some dual-currency Tarfs at a weighted average of $0.87 to the Australian dollar or $1.44 to the euro, depending on which currency was exercised. The maximum deliverable amount under these contracts was A$290.7 million or EUR160.4 million.

In the event that the currency does not appreciate as anticipated, the losses are magnified by the selling of two puts per strip by the investor to the counterparty. In Citic Pacific's case, the Australian dollar did not perform as anticipated, but weakened against the other three contract currencies, resulting not in cumulative gains but magnified losses.