Question
address and answer the following questions:
a) Identify the stakeholders who were affected in the case.
b) What were the expectations—and the fears—of the South Korean exporting firms that purchase the KiKos?
c) 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? Why?
d) Did the government have an obligation to step in and intervene in the actions of the exporters and the banks? If so, why? If not, why not? What actions could the government of South Korea taken?
e) After reading the case, how do you think the balance of trade was affected in South Korea?
f) 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 client?
Requirement 2. The essay should: (a) introduce the problem being explored; (b) offer an arguable thesis statement; (c) provide context/background of the problem; (d) discuss ethical considerations from the perspectives of exporters, banks, and government regulators; (e) discuss economic effects; and (f) issue two evidence-supported.
Solution
FIN Week 2 Assignment
Globalization makes it possible for manufacturers to export and import goods across borders. At the same time, globalization also exposes traders to a myriad of risks, the major being currency risk. “KiKos and South Korean Won” is an example of a case scenario where exporters faced exchange rate risks. Notably, the South Korean Won appreciated steadily against the U.S. dollar, thus reducing export margins for South Korean traders. Despite South Korean banks introducing options and KiKos to hedge against the risk, the hedge failed to adequately protect traders when the spot rate moved below the knock-out-rate. Options were favourable instruments to hedge against exchange rate movements. However, banks of South Korea should have been neutral to the exchange rate fluctuation and intervened through regulatory policies, to prevent the disruptive nature of the derivative market and protect exporters against the undesirable “lock-in-rate”.
Affected Stakeholders
South Korean exporters were the key stakeholders affected in the selected case. Notably, the exporters faced currency risks, whereby their export margins reduced as a result of currency fluctuations (Ahmed, 2015). As is evident from the case, the South Korean Won appreciated steadily relative to the U.S. dollar. Subsequently, the exchange rate volatility negatively affected exports, which were mainly paid in U.S. dollars (Thuy & Thuy D, 2019). The South Korean exports became less profitable, as every dollar paid by foreigners was exchanged for a few Won. Therefore, South Korean exporters were the majorly affected stakeholders by the appreciation of domestic currency relative to the U.S. dollar.
Fears and Expectations of Exporting Firms
In response to the exchange rate risks, banks in South Korea introduced KiKos and options, which raised the expectations of steady margins on sales among South Korean manufacturers. Notably, options provided an opportunity for South Korean traders to buy an underlying asset at present for a profit, and to reduce losses associated with changes in exchange rates (Wanga, 2017). As is evident from the case study, KiKos and options assured exporters that the exchange rate would not move significantly from the trading range (Norris, 2009). As such, South Korean exporters expected that by purchasing the options, they would maintain steady profits in the highly competitive markets.
Despite the high expectations, there were fears associated with the lack of a “locked-in-rate”. For exporters to be protected by KiKos and options, the spot rate had to be within the knock-in and knock-out rate (Norris, 2009). The implication of this was that South Korean Manufacturers would not sell dollars at the hedged rate if the Won appreciated above the knock-out rate in the hedging agreement, a policy that created fear among traders.
Unrefutably, the South Korean bank had the responsibility and duty to protect the interests of its customers. As observed by Chui (2012), the mechanism of options is based on the right of a purchaser to buy or sell an underlying asset after paying an option premium. The option premium obliges the bank to protect the interest of the seller under circumstances when exchange risks occur. Nonetheless, based on the analysis of the case scenario, it appears that the South Korean banks were at fault as they failed to offer protection in most critical circumstances. Rather than hedging excessive appreciation of the Won, banks over-hedged exporters in the knock-in position. The implication of this was the creation of a pure speculative scenario whereby exporters seemingly used options to maximize profits from exchange movements rather than hedge the risk of currency appreciation.
The government of Korea also had an obligation to intervene in the actions of the exporters and the banks. The intervention would be critical in mitigating the occurrence of a financial crisis. As the literature suggests, there is an existing view that derivates are to blame for shattering financial stability, a situation that presented itself in the case scenario (Miruna & Horia, 2015). Notably, the decision of banks of South Korean to over-hedge exporters increased the ability of the latter to profit significantly from the spot rate. Besides, probable use of options as a speculative instrument posed a potential threat to the country’s financial stability, as exporters were likely to utilize the exchange rate movements to reap maximum profits and increase money circulation in South Korea. An increase in money circulation among exporters would then trigger inflation in South Korea and adversely affect the country’s economy in the long-run. Therefore, the government had an obligation to intervene in the derivative market and lower the chances of such effects taking place.
To prevent the adverse effects of the derivatives market, the government of South Korea could have introduced regulatory frameworks to govern the financial activities of the banks. For instance, the government could have adopted some of the regulatory reforms of the G20 summit, such as the requirement for over the counter (OTC) contracts to be reported to trade repositories (Miruna & Horia, 2015). Such measures would allow an adequate review of the KiKos and options structure to eliminate components of the options that created speculative positions for exporters and reduce the probability of the instruments disrupting the country’s financial stability.
Economic Effect
South Korean’s trade balance is likely to have been negatively affected by the exchange rate risk. As observed by Manual and San (2019) exchange rate is among the key factors that affect trade balance. Murshed et al. (2014) also theorize that currency appreciation causes a fall in the trade balance. When the domestic currency appreciates, it makes exports more expensive to buyers using foreign currency and imports cheaper. The variation in the value of exports subsequently leads to a trade deficit in the country with an appreciating currency. In the case context, South Korea likely suffered a trade deficit as exports became expensive to foreign buyers and less profitable to domestic traders.
Ethical Considerations from the Perspective of Banks and Exporters
Banks
The most significant ethical consideration from the banks’ perspective is a justifiable use of derivatives in terms of utilitarianism. In particular, the use of options by banks of South Korea can be evaluated based on the benefits and costs on society (Chaudhary & Soni, 2013). On the one hand, the KiKos and options gave exporters the opportunity to hedge risks associated with exchange rate movements. Subsequently, the exporters benefited greatly by maintaining consistent margins from their sales. On the other hand, options posed the risk of disrupting Korea’s financial stability, as exporters assumed the position of speculators rather than hedgers. However, the costs of the options were inadvertent as the primary reason for the introduction of KiKos was to service exporters’ hedging needs (Norris, 2009). An analysis of the above scenario reveals that the benefits outweighed the costs; thus, it was ethical for banks to promote KiKos and sale and purchase of options.
Exporters
The ethical consideration from exporter’s perspective is a justifiable use of options in terms of transparency. Notable, it was the ethical obligation of exporters to maintain the highest level of transparency when buying and selling the options. As is evident from the case, exporters were required to deliver the dollars to the bank at the specific knock-in rate (Norris, 2009). If exporters delivered all the dollars earned at both the knock-in rate, then it would be justifiable to use options, as its utilization would be transparent.
Recommendations
The main issue in the case scenario was the lack of adequate protection to exporters and potential risks of options on South Korea’s financial stability. To counter the issues, the banks of South Korea should have been neutral on the exchange rates. As observed by Kaminka and Bouquet (2016), one of the principles used in options is placing a bid for an option on a price less than risk-neutral value. Evidence from the case study reveals that the banks failed to observe neutrality, as they set the strike rate close-in to the current market rate (Norris, 2009). Consequently, a decline of the spot rate below the knock-out rate exposed exporters to huge losses as they incurred operational costs in the domestic currency and received payment in U.S. dollars. Therefore, to hedge the risks adequately, the banks should have been neutral to the exchange rate movement and set the strike rate at a neutral market position.
The government should also have intervened to reduce the potential risks of options on the country’s financial stability. As is evident from a prior study, countries such as the United States have for the past decades implemented legislation to reduce systemic risk and increase transparency in the derivatives market (Miruna & Horia, 2015). Having been successful in other countries, the South Korea government should also have enacted necessary legislation to mitigate the disruptive nature of options on the nation’s financial stability.
Lessons from the Case
Among critical lessons from the case scenario is the need for buyers to purchase options that serve their needs adequately. As is evident from the case, options offered by banks in South Korea failed to provide adequate hedging services to exporters. As such, exports were less profitable when the spot rate moved below the knock-out rate. Such lessons would be communicated to clients through actual illustration during a consultation. Notably, I would gather information on existing instruments in the country and explain the limitation of each option to the client’s needs.
Conclusion
The outcomes of the introduction of options and KiKos in South Korean derivative market clearly signifies the adversities of exchange rate risks and an unregulated derivatives market. As can be seen from the case study, exporters incurred less profits due to the steady appreciation of the domestic currency in a highly competitive market. While options and KiKos were introduced to provide hedge services, they failed to achieve the desired outcomes as banks were unneutral to the exchange rate movement. Also, the unregulated market posed potential risks to the country’s financial stability. In response to the highlighted problems, the government of Korea should have intervened in the actions of the exporters and banks by introducing legislation to regulate option contracts. Additionally, banks should have been neutral in setting the strike price to ensure that they protect the interests of exporters. As long as the derivative market remained unregulated, the interests of all stakeholders would remain unaddressed.
References
Ahmed, L. (2015). The effect of foreign exchange exposure on the financial performance of commercial banks in Kenya. International Journal of Scientific and Research Publication, 5(11), 115-120. http://www.ijsrp.org/research-paper-1115/ijsrp-p4718.pdf
Chaudhary, P., & Soni, V. (2013). A utilitarian perspective on business ethics. IOSR Journal of Humanities and Social Science, 14(5), 75-80. https://www.academia.edu/4815194/A_Utilitarian_Perspective_on_Business_Ethics
Chui, M. (2012). Derivatives markets, products and participants: An overview. IFC Bulletin, 35, 1-3. https://www.bis.org/ifc/publ/ifcb35a.pdf
Kaminka, G.A., & Bouquet, F.P. (2016). ECAI 2016: 22nd European conference on artificial intelligence, 29 August-2 September 2016, The Hague, The Netherlands – including prestigious applications of Artificial Intelligence (PAIS 2016), parts 1-2. IOS Press. ISNB: 1614996725, 9781614996729
Manual, V., & San, W. (2019). Dynamic relationship between trade balance and macroeconomic elements: Empirical evidence from emerging economies in Malaysia. International Journal of Recent Technology and Engineering, 7(5S), 47-54. https://www.ijrte.org/wp-content/uploads/papers/v7i5s/Es212401751919.pdf
Miruna, P.M., & Horia, T. (2015). Recent reglementation of derivatives markets to answer disturbances. Procedia Economic and Finance, 32(2015), 1453-1458. http://creativecommons.org/licenses/by-nc-nd/4.0/
Murshed, C.N., Sharmina, K., Shamima, E., Samin, U., & Poly, F. (2014). Relationship between the exchange rate and trade balance in Bangladesh from year 1973 to 2011: An econometric analysis. International Journal of Economics, Commerce and Management, 2(11), 1-26. https://www.researchgate.net/publication/329100356_Relationship_between_the_Exchange_rate_and_trade_balance_in_Bangladesh_from_year_1973_to_2011_An_econometric_analysis
Norris, F. (2009, April 20. Bad trades, except in Korea. New York Times. https://www.nytimes.com/2009/04/03/business/03norris.html
Thuy, V.N., & Thuy, D.T. (2019). The impact of exchange rate volatility on exports in Vietnam: A bounds testing approach. Journal of Risk and Financial Management, 12(6), 1-14. https://doi.org/10.3390/jrfm12010006
Wanga, G.G. (2017). Hedging exchange rate risks. Walden University ScholarWorks. https://scholarworks.waldenu.edu/cgi/viewcontent.cgi?article=4476&context=dissertations
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