Money for nothing!!!!!!!

Essay by vyasdhavalUniversity, Master's August 2005

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Banks have become amazingly expert at packaging derivative products to look like money for jam. And its remarkable how many normally sound CFOs are being attracted by these offers, which really pack a sucker punch.

One particularly "attractive" structure doing the rounds is as follows:

The company and a bank enter into a swap for, say, Rs 50 crore, where the bank will pay the company Rs 50 crore plus 2.2 per cent (that's the Rs 1.1 crore for free, apparently) at the end of one year, while the company will pay the bank 13.27 million Swiss franc at the then prevailing market rate. (13.27 million is the Swiss franc equivalent of Rs 50 crore today, at 1.1550 CHF/USD and 43.50 USD/INR).

Of course, this would subject the company to risk, and so, to protect the company from the risk, the bank will also embed two options into the transaction, which will only expose the company to the market if the Swiss franc rises above 1.01

(to the dollar); on the rupee side, the company is protected beyond 44.50 to the dollar.

The bank, helpfully, also points out that the lifetime high of the Swiss franc, hit in April 1995, was 1.1150, that's a full 10 per cent stronger than the level at which the protection gets knocked out--the implication being that the probability of the protection being knocked out is quite remote.

On further reading, however, the structure gets more complex. In return for providing this protection (at 1.0100), the bank needs the company to give up some upside. This give-up is structured so that if at any time in the last month of the option, the Swiss franc trades weaker than 1.2375, the company has to buy the 13.27 million Swiss franc that it has to pay...