Monday, 23 February 2009

Legal risk, FX risk, and big moves

Suppose a bank buys an option written by a corporate. It ends up in the money. The bank hopes that the corporate will pay out.

But what if lots of other banks have bought the same type of option from lots of corporates. Very few of them hedged, and all the options are far in the money.

Now the banks have a systemic problem. Perhaps many of the corporates cannot afford to pay. In any case, their losses may be sufficient to cause government intervention. The banks may be caught in a storm of protectionism.

It seems, according to FT alphaville, that this is possible for the counterparties to Eastern European corporates on FX options. The corporates, in many cases I am sure with full understanding of the risks, sold zloty, koruna and forint downside as a Euro convergence play. All three of these currencies have fallen: the corporates have taken significant losses. And now, of course, the lawyers are getting involved.

The lesson, then, is that it is good to be right when selling options. Being a little bit wrong is bad. But if you are really really wrong, and lots of other people are too, that's fine, because the government will probably bail you out.

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