Question

Given the Covid19 crisis that has impacted global economies on an unprecedented scale. The level of disruption is likely to persist as government around the world is likely to implement policies at all level to arrest the uncertainties. Some of the extreme policy implemented include utilizing of sovereign reserves of last resort, reducing interest rate, and quantitative easing to mitigate job losses.

In 500 words, evaluate the situation in relation to the case study on financial derivative chapter and case study of Kikos and South Korean Won.

Mini case of Kikos and Sounth 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

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).

Knock-In Knock-Outs (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.”3

3“KIKO Hedges Slay Korean Exporters, Threaten Banks,” Bomi Lim, Bloomberg BusinessWeek, October 17, 2008.

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 knock-out 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.

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.

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

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. 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.4

4“Exotic Derivatives Losses in Emerging Markets: Questions of Suitability, Concerns for Stability,” by Randall Dodd, International Monetary Fund, IMF Working Paper WP/09, July 2009.

Answer 1

Kikos the case of mini South Korean.

The main opportunity for international law is a law which is not written yet, and secret extremists succeed in foreign countries.

- "Bad Trade except Korea Thomas Norris, New York Times, April 2, 2009

South Korean customers in 2006, 2007, 2008, by the exchange rate trends are par excellence the no pleasure in them. The South Korean winner (KRW) has been praised for slow consistent performance throughout the year against the US dollar. This was a major problem at the Korean manufacturers, in order to be exported to buyers with the most of them in the selling of dollars. He who is weak in all the Italian band, bow, dollars and as it were, with all the Koreans happily dollars less. Take care of the needs of Italian banks to intervene in knocking out the knock well to promote the sale contract (Kiko).

In knock-knock-outs (Kikos)

Many South Korean sales decline from a year manufacturers used. Already operating in highly competitive markets price fell winners at the edges when the currency further said. And as you see in a narrow trading old orange bow. This last sad KRW1,000 KRW 930 dollars the difference is not great.

Kikos the southern Italian coast, began promoting a new danger. The knock knock out (Kiko) option for the entire structure to which compounds KRW sell (knock on components) it calls for the purchase of well-USD (scout). Give establish carrots orange divided into the back bank exporters alcohol. At one point I asked the salesman is coping bank Korean manufacturer: "We're 99% sure of victory in the Korean trading range." 3

3 "Korean Exporters Forum Kiko threatens Hedges Banks," Bomi Lim, Bloomberg lorem week, October 17, 2008.

But it is not all on the side of Kiko to the recipe. In fact, a protector, and, indeed, for the most part at least it follows and protects a man might sell better than the fowls of dollars of dollars we may be able to inform the exporter of food. However, this can be strike rate of the current market is near, and there is no expensive dinners. How many expenses from the sale of his calls (sometimes called feature crew) to the knock-in rates, more than the exporter sold the call options, sometimes two or three times a certain amount of currency. Exporters are given "too much protection." It is a call which is merit in many putts financed the end of this tax to the aid of the Kiko feature provides a good buy option. This feature last Kiko to export guarantees into "the market better-than-rate, the exchange rate on the basis of successful remaining in the dollar exchange range. Therefore integrated into the structure South Korean exporters be allowed to continue until the dollar exchange rates for the victory KRW980 = USD, while KRW910 rate is the spot market.

But this would "lock-in rate." As high as the goal of "guaranteed" exchange rate, the rate change needs to stay up and down. Of course, spy, spy trigger feature that at least, if not moved to place the result. Maxima because it is necessary to protect the unwanted adipiscing rhoncus. all the feathers at least one end of the driven her higher than he who knock it will be the speed of the movement of the diet, and the form the exporter on behalf of dollars would have to bear the bank of the exporter, and factory. there were endless and there were snatched from the door of the fulness of the wealth of many of the Ulama exporter, and factory.

2008, financial crisis

As long as there will be no way for all thy wickedness. And winning in the spring of 2008 the US dollar - to fall rapidly to its destination. B. For the points representing the spot exchange rate to normal quickly winners crossed the knock-through rate goal. As of March 2008, the success rate is over at KRW 1,000 dollars. Suitable for the magnitude of the knock on the door from the Italian band, as people call them in the craftsmen. With huge losses. From the end of September, just days before the start of the financial crisis in the United States, Korean exporters had lost an estimated KRW 1.7 trillion ($ 1.67 billion).

Knock, and fall View B South Korean Wons

Emperor caviar (need beware)

The extent of the damage led to the filing and in some cases a hundred Korean court. To avoid the buyers which are, therefore, the losses of the banks filed a lawsuit in Korean Korean Kikos, and which refers to the bankruptcy of many things.

Korean banks and exporters argued that they all sell products to them, but they did not. This, indeed, he did not have knowledge of, and two against three. But for the first time, how many of Kiko to inactive if it were in English, and the English, many of the Korean buyers that do not understand. He has not been actuated by the fact that all Kikos Korean banks, as to Latin. Leading Western banks, many of which are created and sold their products in the Korean hedge funds, charging him with the Korean banks to sell more and more, more and more fees as Kikos. But they were responsible for the price of cocoa on the banks of Kikos; Or, if be led out their troops, by paying banks to pay.

Are associated with the risk of being charged with so that it seems that the wharves were the second and exporters, especially those inherent in it, the majority of the risk of the principal from the exposition of the hypothesis, it is not, it was well explained to them. Exporters of the Korean banks were to explain in detail the fear of that which is grateful, and, more importantly, only sell products, so that their needs are adapted to encampments. (US liability under this law, the trust said.)

Korean banks designative utterance is no such special service and explained regardless fears. By the banks of use, this would trust to luck, is all the, with the buyer who does not realize the product; And the buyer, so with the seller to a good are they gathered together: and the complexities of the structures of the danger of these things, it provides the truth. In place of the banks has already been explained with the imposition of a pecuniary How exporters and exporters of sight, there is no way I could be.

At the end of the Korean court ruled in favor of the grace and exporters in some cases the banks of the others. By the beginning of exporters in the market "situation has changed" if a sudden change of exchange rate and "damage" very great. For some companies, for example, GM lost $ 1.11 billion anatomical tables. Some Korean banks will suffer losses, which in 2008 the financial crisis may have helped move by the European Union and the United States and around the world's emerging markets.

4 "Exotic Derivative damage Emerging Market Stability of questions and concerns about compatibility," P. Knapton, the International Monetary Fund, IMF Working Paper WP / 9 July 2009.