Derivatives are making news globally as well as in India. While the former have been dominating the global business media for about six months, the latter are being increasingly reported and commented upon ever since Hexaware [Get Quote] announced the losses it had incurred.

My firm has consistently advised our corporate clients against using either complex structures or taking speculative positions - and we have been branded by segments of the banking industry as being too conservative, if not 'old fogies'.

In too many cases, the word 'hedging' is being used extremely loosely. It was recently reported that Larsen and Toubro lost Rs 200 crore (Rs 2 billion) in 'hedging' its commodity exposures.

On first principles, as also in terms of the accounting standards, risk is defined as the uncertainty of cash flows, or fair values, arising from changes in market prices. "Hedging" is aimed at reducing the uncertainty of outcomes (or at least adverse outcomes) by entering into derivatives (or otherwise).

In other words, the objective of hedging is to reduce (adverse) price uncertainties, and not making profits. In fact, using derivatives for hedging price risks generally has a cost attached to it - payment of a fee for buying options, or opportunity cost in relation to forwards. To my mind, therefore, there is no question of 'hedging' resulting into profits or losses. In fact, profits or losses can arise only when one is deliberately adding to risks (or uncertainties) in the hope of profiting from price movements. This is not 'hedging': the correct description of such activity is 'speculation'.

One also gets an impression that much of our corporate risk management culture does not seem to appreciate the difference between risk reduction and cost reduction; with few exceptions, the latter cannot be done without taking risks; that if deliberate, speculative risk-taking is to be done for reducing cost or making profits, it needs its own disciplines.

The most important ones are that risky positions are taken at market prices (you can hardly hope to make money on a share if you buy it at 50 per cent over its market price); that the mark-to-market valuations are continuously monitored; and that the positions are reversed at pre-determined stop-loss levels when the view goes wrong.

Ready access to market prices and quick exit routes are the sine qua nons of successful risk taking. Cutting losses, and not the ability to predict the future (which, incidentally, nobody has) is the key to success. You need to make more money when you are right, and limit losses when you are wrong - and this cannot be done except when pricing is transparent, readily available and the exit routes clear.

I have been making this point for many years now. Pleading guilty to consistency being the virtue of a fool, and saying "I told you so", I am tempted to quote from earlier articles:

"Between a bank ...and the corporate treasurer facing an array of sophisticated marketing teams, the playing field is hardly level. The attractions of complex derivatives for the bank are obvious: as competition in plain vanilla instruments has shaved profit margins, structured or proprietary products are the way to improve them."

"...one has seen an explosion of complex currency and interest rate derivatives (in India). In principle, the regulator bars the writing of options on the part of corporates, or receiving fees. Many structures seem to evade the restriction - by describing option-based structures as swaps, by paying fee through off-market exchange rates, etc. The so-called range accruals, for example, involve the client to write a series of binary options. I sometimes wonder whether we are not heading for a major dispute - and inviting the heavy hand of the regulator."

"In another recent case, the structure being marketed to an obviously unsophisticated corporate client, with no natural hedge to currency fluctuations, involved swapping INR interest rate into USD (coupon swap), and INR principal into Japanese yen (the Swiss franc is another popular currency for such transactions). The transaction also involved spread options on USD swap rates, purchase of a call option with a knock out feature, and sale of a dollar: yen put option! Regulations also require derivatives to be used for hedging corporate exposures. It is very difficult to imagine what the corporate is hedging through options on the spread between five and one year swap prices in USD!"

"... so many Indian companies have entered into transactions where payments depend on the difference between five- and one-year USD swap rates. It almost seems as if ... any structure is described as a 'hedge', notwithstanding the uncertainties and risks it may be creating."

But why find fault with the corporates, when public sector banks in India have swapped fixed rate coupons on rupee bonds issued by them into floating rate yen coupons, and called such transactions hedges!