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Multinational Business Finance

Fifteenth Edition

Chapter 7 Mini Case

KiKos and the South Korean Won

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KiKos and the South Korean Won (1 of 2)

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

KiKos and the South Korean Won (2 of 2)

South Korean exporters in 2006, 2007, and into 2008 were not particularly happy with exchange rate trends.

The South Korean won (K R W) 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) (1 of 3)

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 K R W1,000 and K R W930 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 KiKo was a complex option structure, which combined the sale of call options on the K R W (the knock-in component) and the purchase of put options on the U S D (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.”

Exhibit A South Korean Won’s Steady Appreciation

For long description, see slide 15: Appendix 1

Knock-In Knock-Outs (KiKos) (2 of 3)

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 K R W 980 = U S D when the spot market rate might have only been K R W 910.

Knock-In Knock-Outs (KiKos) (3 of 3)

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 knockout 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 K R W 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 K R W 1.7 trillion (U S D 1.67 billion) in losses by Korean exporters.

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

For long description, see slide 16: Appendix 2

Caveat Emptor (Buyer Beware) (1 of 3)

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.

Caveat Emptor (Buyer Beware) (2 of 3)

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.

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.

Caveat Emptor (Buyer Beware) (3 of 3)

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.

Some Korean banks suffered significant losses as well, and may have helped transmit the financial crisis of 2008 from the United States and the European Union to many of the world’s emerging markets.

Mini-Case Questions

What were the expectations—and the fears—of the South Korean exporting firms that purchase the KiKos?

What is the responsibility of a bank that is offering and promoting these derivative products to its customers? Does it have some duty to protect their interests? Who do you think was at fault in this case?

If you were a consultant advising firms on their use of foreign currency derivative products, what lessons would you draw from this case, and how would you communicate that to your clients?

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Appendix 1

Long Description for a graph plots the exchange rate for Korean won, or K R W, = U S D 1.00 from January 3, 2006, to February 3, 2008.

A curve represents changes in the K R W to U S D exchange rate relative to knock in and knock out rates, as follows.

The rate falls from near 1,005 in January of 2006 to near 920 in May 2006. The graph then fluctuates between 900 and 960.

The knock in rate is represented by a horizontal line at 980. If the exchange rate rises above 980, the exporter has to take this rate. This scenario is good for the Korean exporter earning U S dollars.

The knock out rate is represented by a horizontal line at 890. If the exchange rate falls below 890, the exporter has no protection because all options expire. This scenario is bad for the Korean exporter earning U S dollars.

In summary, as the won gets stronger against the dollar, exporters receiving dollars turn them into fewer and fewer won. If this trend continues, exporters need protection. KiKos are essentially a bet that the exchange rate will not move far from the current trading range.

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Appendix 2

Long Description for a graph plots the exchange rate for K R W = U S D 1.00 versus time for the period from January 2, 2007, to June 2, 2009.

The graph plots the K R W to U S D exchange rate with the knock in rate = 980 and the knock out rate = 890. The graph represents the trends described in the following list. All values are estimated.

From January 2007 to March 2008, the rate fluctuates between 890 and 980.

In March 2008, the won started falling against the U S dollar, causing the rate to rise above 980 and activating the knock in rate.

By August 30, 2008, more than K R W 1.7 trillion, or U S D 1.67 billion, in currency losses had been suffered by exporter, and the exchange rate was near 1,050.

The exchange rate continued to rise as high as 1,560 by March 2009, before falling and leveling off near 1,260 by May 2009.

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