Asia MBA Business Ethics 12 April 2012

KIKO Case Study Report

Group F
Byounghui Lee(2011418006), Avinash Rao (2011418016) , Swapnil Rao(2011418022) , Rui Zhuang(2011418034), Rui Liu (2011418028)

KIKO Case Study Report Group F

Contents:

1. Introduction 2. Structure of KIKO 3. Most Controversial part of the product a. Profit and Loss calculation b. Is the product Ethical 4. Stakeholders in this controversy a. SME Exporters b. Banks c. Courts d. Government e. International Financial Associations f. NGOs 5. Evaluate whether Korean banks acted ethically in marketing the product a. Information Asymmetry b. Leveraging financial muscle c. Mis-selling d. Incentives e. Analyzing the demand equation 6. Korean Appellate courts ruling a. Legal Perspective b. Ethical Perspective 7. Learning a. Company Perspective b. Bank Perspective c. Government Perspective 8. Appendix I 9. References

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1. Introduction: Between the years of 2006 and 2007, many Korean export companies entered into what is known as the KIKO (knock-in, knock-out) target forward contracts to hedge against the threat of appreciating Korean currency, Won. The contracts gave, among others, exporting companies the right to sell US Dollars for Won at a pre-arranged strike price so long as the exchange rate did not fluctuate drastically. One major caveat was that the contracts were structured in a way that, in the event of Wons significant depreciation beyond a set threshold, the exporting companies which bought these contracts would have to pay a large sum to their contracting counterparties. Unfortunately for these exporting companies, Korean Won depreciated significantly against Dollar in 2008 following the global financial meltdown, exposing these KIKO contract buyers to big financial losses, so much to an extent that some companies were forced to file for bankruptcy. It is reported that, as of August 2008, over 500 companies had entered into the KIKO currency option contracts, vast majority of them being small and mid-sized companies. The exporting companies, facing significant financial losses, brought complaints to regulators such as the Financial Supervisory Service and the Korea Fair Trade Commission and started a series of lawsuits against banks in an effort to invalidate their KIKO contracts, based on grounds that include fraud, mistake, and changed circumstances. In several of these cases, the courts granted preliminary injunction to these exporting companies and, in some other cases, the courts have found the banks partially liable, which have sparred vast controversy in Korea and beyond. [1]

KIKO Case Study Report Group F

2. Structure of KIKO The KIKO currency option contracts are unique in that, in addition to granting a put option to the contract buyer, it also gives two call options to the contract-selling bank. We illustrate a specific example of a KIKO contract to show the structure of KIKO contract, assume that a company entered into the KIKO contract worth $100,000, with the following features: (1) Strike price of 1000 Won/Dollar; (2) knock-out rate of 900 Won/Dollar; (3) knock-in rate of 1,100 Won/Dollar; (4)1:2 leverage. Scenario#1:If the currency exchange rate does not go above 1,100 Won/Dollar or below 900 Won/Dollar during the contract period, and if the exchange rate at maturity is, for instance, 960 Won/Dollar (or, more generally, below 1,000 Won/Dollar), then the company will exercise its PUT option by selling Dollar at the above-market strike price of 1000 Won/Dollar, for a gain of 4,000,000 Won. Please refer Exhibit 1 in Appendix I for the illustration. Scenario#2: If the currency exchange rate does not go above 1,100 Won/Dollar or below 900 Won/Dollar during the contract period and if the exchange rate at maturity is 950 Won/Dollar (or, more generally, above 900 Won/Dollar), then the company will

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simply sell Dollar at the market rate since the market rate is higher than the strike price. Please refer Exhibit 2 in Appendix I for the illustration. Scenario#3 (Knock out):If the exchange rate falls below 900 Won/Dollar during the contractual period, the contract loses its effectiveness, leaving the company vulnerable to any exchange rate volatility. Please refer Exhibit 3 in Appendix I for the illustration. Scenario#4 (Knock In):If the exchange rate rises above 1,100 Won/Dollar during the contractual period, the company would be obligated to sell Dollars at the request of the contracting bank. In such a case, due to the 1:2 leverage structure, basically the bank exercises two CALL (right to buy for the bank) options. The amount that the company would have to sell becomes $200,000; not $100,000. Thus, if the exchange rate is 1,150 Won/Dollar (or, more generally, above 1,000 Won/Dollar) at maturity, companies would have to sell $200,000 at the strike price of 1000 Won/Dollar. Please refer Exhibit 4 in Appendix I for the illustration. 3. Most Controversial Part of the product: 3.a Profit and Loss evaluation: We calculated the profit and losses for all the above situations, values are provided in Exhibit 6 of Appendix 1. Here the amount lost due to the knock in condition is two times the rate of profit made if there are no violations in the contract. Its a tradeoff between Limited Gains vs. Unlimited Loss. Please refer exhibit 5 in Appendix 1 for the calculation. Also refer exhibit 6 in Appendix I, containing 3.b Was KIKOs design ethical? When we compare KIKO with other Vanilla hedging contracts, we cannot help but ask ourselves the question- Why the limitless losses? What might be the rationale behind 5

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designing components such as knock in with a 1:2 leverage ratio? It becomes clear that the intent is to cash in on the rare event occurrence and amass hoards of profits. But what makes it even more unethical is the fact that these profits come at the expense of livelihoods of nave companies which have fallen prey to these high risk schemes devised by banks. During our research on these so called rare events we discovered something staggering. According to the centre for research on Economic and Financial Cycles and the Federal Reserve bank of Atlanta, the probability of a recession occurring is cyclical and is extremely high every 10 years (refer Exhibit #7). If you think about it the KIKO contracts were designed and pushed into the market in 2005. Having the above mentioned knowledge, it becomes very difficult to deny, that the designers of KIKO were actually counting on a financial meltdown.. This may be a speculative but it is definitely worth considering. To further add fuel to the fire, the banks pushed this product over regular Vanilla Hedging derivates. This fact renders the ethical intent behind the KIKO product design questionable. 4. Who are the stakeholders in this controversy? 4.a SME Exporters: Under the expectation of Korean Won's appreciation, export companies need devices to hedge the currency risk. Some SME exporters were forced to enter a KIKO contract because of banks unlawful compensatory deposit practice, where banks force their borrowers to purchase certain financial products in exchange for loans.KIKO buyers may have underestimated the probability of large losses and became exposed to huge loss from the KIKO contracts due to risk over-hedged as the Korean won plunged remarkably since 2008. Since late 2008, many companies that

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purchased KIKO options have filed applications for provisional dispositions on their KIKO contracts. Since then, a series of lawsuits have followed. 4.b Korean banks: Korean banks design and sell complex KIKO products that difficult to understand and marketing the KIKO products via higher incentives for branches. The eight banks that sold the most KIKO contracts reported 2.57 trillion won of profits at market price from outstanding currency-option contracts as of Sept. 30, according to the FSC. 4.c Courts: Since late 2008, many companies that purchased KIKO options have filed applications for provisional dispositions on their KIKO contracts. Since then, a series of lawsuits have followed. In the first ruling, Soosan Heavy Industries Co. lost the case in February 2010. As of November 2010, 99 of the 118 companies that filed similar lawsuits lost. The first decision by the Appellate Court was in favor of banks and against export companies in Aug. 2009. Till April 2009, decisions have been made in 11 cases (ten by the Seoul Central District Court and one by the Incheon District Court). In four cases, the Seoul Central District Court, applying the doctrine of "changed circumstances", granted the companies a preliminary injunction allowing the companies to temporarily suspend the performance of the KIKO contracts pending the final verdict of the main cases. 4.d Korean Government: The supervisory authority was not aware of the potential risks involved in KIKO forwards until big losses were realized by SMEs. The Korean government did not constitute any framework to monitor such financial derivatives in the first place. Although there are multiple financial regulatory bodies set up, none of them 7

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monitor the financial derivatives. The government should have played a more proactive role instead of a reactive one. Then the government after the rulings handed over 1.8 trillion won to firms with currency derivatives losses to stave off bankruptcies. 4.e International Financial Associations: The International Swaps and Derivatives Association, Inc (ISDA) expressed its concern over a series of rulings in the Seoul Central District Court in relation to Knock-in Knock-out (KIKO) currency option contracts litigation cases. The Association is particularly concerned about undesirable

precedents that may harm the development of the derivatives industry in Korea, and in turn its financial stability. In ISDA's view, the Court has set dangerous precedents disrupting the fundamental right to enforceability of contracts in the country. This could expose the country to dampening international investor confidence and in turn increase risk. 4.f Korean NGOs: SpecWatch Korea, an independent speculative fund watchdog, regarded KIKO as a Joint Product of financial giants such as government, banks and opposed the court decision vehemently. 5. Evaluate whether Korean banks acted ethically in marketing the product. Even though Korean banks can evade legal charges, they cannot avoid ethical criticism. The impact of KIKO on SMEs was too harsh and we witnessed several SMEs which had sound financial status went bankrupt all of a sudden due to the huge losses generated by KIKO. So what were the Korean banks ethical problems in marketing KIKO.?

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5.a Information Asymmetry: Firstly, they neglected their duty to explain the chance of unlimited loss. According to many scholars and professionals in this field, KIKO itself was not good enough to hedge the risk from strong depreciation of currency. It could even hurt contractor with limitless loss due (as shown in exhibit 6) to KIKOs asymmetric expected benefit between company and bank. The problem was that banks didnt try their best to notice this possibility to contractors, as it was not in the banks best interest. In US, there was Gibson greetings vs. Bankers Trust case. In early 1990, Gibson greetings, gift card manufacturer was offered new financial product from Bankers trust which was newly established company handling many derivatives products. Gibson greetings agreed to contract this product and earned some amount of money in early stage. Before not long ago, Gibson greetings signed another kinds of many derivative products. However, one day they found that their loss reached 17million US dollars from derivative investment. But it never had been told that there was a possibility of such a huge loss. So Gibson greetings filed lawsuit to Bankers trust and then court judged Bankers trust guilty for neglecting its duty to explain a chance of loss, which was regarded a kind of fraud. The main differentiating point here is in this case, there were recorded tapings clearly indicating the Bankers trust motive. 5.b Leveraging financial muscle: Secondly, Some banks forced to contract KIKO with their SME customers. A corporate client might be forced to enter a KIKO contract because of banks compensatory practice , where banks force their borrowers to purchase certain products in exchange for loans or roll over. SME also might reluctantly buy KOKO contracts only because the buyer had week negotiating power. In this sense , KIKO marketing of bank was an offer couldnt refuse for SME. 9

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5.c Mis-selling: Thirdly, many banks advertised KIKO as a proper hedge product for SME even though it was neither a customized nor a packaged product appropriate for hedging foreign exchange market. According to many news papers, bank did huge promotion trough AD to sell KIKO product and emphasized that it was optimal product for hedging with no initial cost. But in fact KIKO product was effective only when currency had appreciation. So it brought totally opposite result to many nave SME contractors. 5.d Incentives: Fourthly, Some banks put strong incentives to sell KIKO in the branches even without having enough knowledge of KIKO. Even worse some banks advertised KIKO as a special offer which was a chance to make a money easily. Even though many bankers thought themselves as professional in their field, majority of them didnt recognize that KIKO could bring unlimited loss. So they just wanted to boost up sales relying on past 2years stable exchange rate trends. If they knew KIKO could be very dangerous weapon when currency had non-sizable depreciation, they might have reconsidered sales of KIKO products. 5.e Analysis of the Demand side of the equation Vast majority of the Korean exporting companies that signed the KIKO contracts were small to mid-sized companies which most likely lacked sufficient analytical capability to assess the future volatility in the foreign exchange market and to make an adequate arrangement to hedge against foreign exchange risks Myopic companies would unduly focus on the short-term dimensions of the contracts and pay insufficient attention to the long-term dimensions. 10

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Wons relative stability during the several years prior to their signing of the KIKO contracts was perhaps a salient feature in the foreign exchange market, while Wons volatile move in the previous decade somehow disappeared or was discounted heavily in their analytic minds. Please refer exhibit 8 in Appendix 1 for the exchange rate fluctuations between 2002 - 2007 Generally, optimistic bias includes behavior that over-estimates the likelihood of positive events, and under-estimates the likelihood of negative events Human beings have an inherent tendency to follow what others do, and such tendency may have played an important role in making the KIKO contracts suddenly popular among many exporting companies 6. Korean Appellate courts ruling 6.a Legal Perspective: In the first ruling, Soosan Heavy Industries Co. lost the case in February 2010. As of November 2010, 99 companies lost similar lawsuits in Korea. We generally agreed with Korean Appellate courts ruling from legal perspective. The reason is: There is nothing wrong with the KIKO product itself, but it is dangerous if used improperly. One of the greatest moral traits of free markets is that they rely on voluntary cooperation, which means that if a deal doesn't suit you; you can walk away from it. This, however, requires discretion on both sides, that is, the proper consideration of risk and opportunity. If you feel you don't have enough information about a product or service to make an informed decision, then walk away. You are allowed to do so. 11
[1]

KIKO Case Study Report Group F

All of which merely seeks to excuse ignorance and rationalize a bad decision. The Seoul High Court ruled that the terms and conditions of the KIKO contracts were neither unfair nor unreasonable because, among their things, the applicant would not have incurred large losses under the KIKO contracts so along as it had not over-hedged its position since the applicant had constant inflow of foreign currency from its export business. Korea Fair Trade Commission determined that it would not be possible to declare that the KIKO contracts are overall inherently unfair to the companies since the end result of an individual contract would be different depending on exchange rate fluctuations. 6.b Ethical Perspective: However, if we think this question from business ethics perspective, without proper supervision, financial derivatives can be misused to increase overall instability of the market. We could find some further reasons that the bank and client are not in the same equal position in KIKO contract. A corporate client might force to enter a KIKO contract because of banks unlawful compensatory deposit, and client had a weak negotiation power. The bank may force their borrowers to purchase certain financial product in exchange of loans. The KIKO buyers may have underestimated the probability of large losses. The information of this product is asymmetry. Banks refrain from advising products that may not fit with their customers best interest.

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KIKO Case Study Report Group F

Banks have a duty to acquire and maintain certain level of understanding about their customers and also have a duty to fully explicate financial risks involved with their products. 7. Learning and recommendations: We learn from the case from 3 perspectives: The company perspective, the Banks perspective and the Government Perspective. 7.a The Company Perspective: 1. Companies should not invest without complete knowhow of the product. They must access and manage their investment risks. 2. Companies should not Over-hedge in products with high risk 3. Companies should Counter Hedge to reduce overall risk and ensure minimum losses in crisis situations like the 2009 global financial crisis. 4. Companies should not fall into the Hedge-and-Forget Trap. They should continuously monitor their investments and be quick to respond to market volatility. 7.b The Banks perspective: 1. Banks should design ethically sound products which are fair and equally balanced. 2. The banks must be very transparent while communicating about the product while selling it to the customers. They must not attempt to hide any part of the 13

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product especially the risk factor from the customer. They should not force or hard sell the product to customers 3. Banks should inform clients of potential threats to their organizational health when sensed. It is the moral and ethical obligation of the bank to warn the customer of the possible threat. 4. Banks should have and provide a contingency plan to customers. 7.c The Government perspective: 1. The Government should be aware and proactive towards suspicious financial instruments such as KIKO. 2. A Financial and Regulatory Committee must keep an eye on such dicey financial products. Regulations must be enforced on both the design and marketing of such high risk products. 3. The Government should introduce financial programs such as PCBO to ease liquidity constraints and support victims, as damage control.

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8. Appendix I
Exhibit 1: Companies exercising Put option

Exhibit 2: Companies not exercising Put option

Exhibit 3: Knock Out Condition

Exhibit 4: Knock In Condition

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Exhibit 5: Profit and Loss calculation

Strike Price 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000

Market Price 910 950 960 970 980 990 1010 1020 1060 1080 1090 1100

Profit / Loss Calculation (Won) 9000000 5000000 4000000 3000000 2000000 1000000 (2,000,000) (4,000,000) (12,000,000) (16,000,000) (18,000,000) (20,000,000)

Assuming within the contract period, the Knock in Value was reached, then the bank will exercise their two Call options

Exhibit 6: Plotting exhibit 5, on a profit/loss vs. market price

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Exhibit 7: Smoothed Probabilities of Recession: Source CREFC

Exhibit 8: Exchange rate Won/Dollar

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9. References:
[1] How Koreans Deal With Foreign Exchange Rate Risk: A Behavioral Law and Economics Perspective on the KIKO Forward Contract by Haksoo Ko and William J. Moon [2] New Financial Products and their Impact on the Asian Financial Markets by Sangche Lee, Jung-Han Koo [3] Playing with fire Randall Dodd [4] Lessons from the KIKO debacle and Alternatives for SMEs that want to hedge currency risk Kwon Sehoon [5] The global crisis and Koreas international financial policies by Thomas.D.Willet [6] Korean Corporations Court Bankruptcy With Suicidal KIKO Options Bloomberg by Yoolim Lee [7] KIKO' Hedges Slay Korean Exporters, Threaten Banks Bloomberg -By Bomi Lim [8] Outcry over Korean Kiko suspensions Financial Times - By Song Jung-a in Seoul [9] The notorious KIKO disputes Yoon and Yang LLC [10] CREFC:l Center for Research on Economic and Financial Cycles Smoothed probabilities of recession

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