Mexico and Brazil come to terms with meaning of exotic
Some Brazilian CFOs have lost their jobs because of Tarns (target redemption notes, or swaps or forwards), notably at Sadia and Aracruz. Now more aptly nicknamed the products from hell, they account for losses across many emerging markets including Brazil, Mexico, Korea, Poland and Indonesia. A fundamental question stands at the heart of the debate about these products: were the firms speculating or hedging with them? And did the banks acting as derivatives dealers intend to meet their clients’ needs or to deceive unsophisticated CFOs with complex asymmetrical products?
The Tarns provided a long position in local currency for corporates. The derivatives generated monthly payments for a period of one or two years, with the investor gaining from an upward movement in the underlying price and registering losses from a downward movement. Potential gains were capped, with many contracts carrying a knock-out provision if the foreign currency appreciated beyond a specified range. However, in contrast, potential losses were not only unlimited but could occur at a rate that was usually twice as fast as the decline in the underlying exchange rate.