Derivatives: Korea’s kiko fiasco
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Opinion

Derivatives: Korea’s kiko fiasco

Don’t just blame the locals: these are age-old derivatives-based losses.

The controversy surrounding Korean companies’ attempts to free themselves through the courts from kiko (knock-in, knock-out) derivatives contracts, after the won’s spectacular fall this year threatened to wipe them out, has offered many market participants the opportunity for routine Korea-bashing.

Such problems are the price that banks must pay for doing business in Korea, the argument runs, and it was ever thus.

Whatever the relative robustness of contract law and its enforcement in Korea might be, however, to make this argument is to ignore the fact that the present mess is at heart a typical derivatives blow-up. Lessons are familiar but they could and should be learnt from.

The contracts in question are currency hedging options taken out by Korean companies last year as insurance against the then consensus that the won would appreciate further. The kiko structure means that under certain conditions the contract would reduce the clients’ obligation to buy and sell the paired currencies to nil – it would "knock out" – whereas under other conditions it would remain at the nominal amount or indeed double in size to "knock in" an effective second contract.

When the Korean won did not in fact appreciate at the start of this year, but fell dramatically, the clients discovered that there was no cap on their losses under the structure and launched a volley of lawsuits against the banks that had sold them the contracts.

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