Abstract
Between 2006 and 2007, hundreds of export-oriented South Korean companies entered into what are called KIKO (knock-in, knock-out) target forward contracts to hedge against the threat of an appreciating Korean currency, the Won. Buyers of these contracts were assured a pre-determined foreign exchange rate as long as the range of exchange rate fluctuation stayed within a narrow band. In 2008, however, the Korean currency depreciated considerably following the global financial crisis, forcing buyers of the KIKO contracts to incur enormous losses. Why were there both supply and demand for these contracts, and why did they become suddenly popular? This article employs a behavioral law and economics perspective to explain what transpired in the minds of the parties to the contracts. Psychological biases and cognitive limitations were perhaps at play, including herd behavior, investor myopia, information cascades, and optimism bias. Recognizing that these psychological factors could induce sub-optimal decisions of the contracting parties, we argue that de-biasing should be considered an important policy goal in financial contracting. While the scope of this paper is limited to the KIKO contracts, the principles used to examine this case can be broadly applied.
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Notes
These contracts are commonly called “KIKO contracts,” so in this article, we use the term the KIKO contracts or the KIKO currency option contracts to refer to these contracts. There are variations of these contracts and such variations have different structures and different names but, for the purposes of this article, the variations and resulting differences are not significant.
The Won, which closed at 935 Won per Dollar in 2007, for example, closed as low as 1525 Won per Dollar in late November of 2008, Kim (2008).
Lee (2009).
As of June 2008, small and mid-sized exporting companies accounted for 480 out of 519 companies that entered into KIKO contracts. Lee and Kim (2009, p. 48).
For the purpose of this paper, “exporting companies” refers to companies that sell goods abroad for their primary source of revenue.
The Won-Dollar exchange rate is the most important exchange rate for many Korean exporting companies. The KIKO option contracts were mostly regarding the Won-Dollar exchange rate, although there were contracts involving other currencies such as Japanese Yen. In this article, for expositional convenience, the exchange rate is used to mean the foreign exchange rate between Dollar and Won.
The KIKO currency option contract is typically a hybrid contract including both the exporting companies’ put option and the banks’ call option. This structure allowed the parties to structure the contract in a way that both could realize identical overall expected profits, which in turn allowed lowering premium fees for the companies. Perhaps reflecting this structure, the KIKO contract was described and marketed as a “zero-cost” product.
This example resembles a typical window of a KIKO target forward contract. With a “window” barrier, the calculation as to whether knock-in or knock-out would be activated is done relatively frequently, e.g., on a monthly basis, while the contract’s overall term may be 1 year. See Lee and Kim (2009, pp. 19–20).
With the 1:2 leverage structure, buyers of the KIKO contract would be responsible for coming up with twice the amount of currency they have signed for, which leads to the amplification of their losses in the event that incurring losses are inevitable for the buyers. The KIKO contract with 1:2 leverage was the most common type among various possible leverage alternatives, although there were some contracts with 1:1 leverage or 1:3 leverage structures.
A typical contract period is 1 year, and oftentimes the calculation to determine whether to activate the knock-in or knock-out features is done on a monthly maturity basis. For simplicity, the illustration in the text is given based on the assumption that the contract period has only one maturity. The illustration also ignores fees charged by the banks.
For instance, Morgan Stanley, in December of 2007, predicted that the currency would hover around 900–930 Won/Dollar throughout 2008; Citi Group estimated the figures to be between 880 and 900 Won/Dollar during 2008; and Korea Development Bank predicted that the average exchange rate for 2008 would be 905 Won/Dollar. Forecasts of these institutions announced toward the end of 2006 about the foreign exchange rates in 2007 were generally similar, with slightly higher rates. See Lee and Kim (2009, p. 42).
For instance, the forward exchange rate was lower than the market exchange rate in the spot market. Specifically, as of December 3, 2007, while the exchange rate in the spot market was 938.6 Won/Dollar, the forward exchange rate was 934.2 Won/Dollar with 1 month maturity, 925.6 Won/Dollar with 3 month maturity, 922.6 Won/Dollar with 6 month maturity, and 921.6 Won/Dollar with 12 month maturity. This clearly indicates that the market was expecting the continued decline of the Dollar. Korea Federation of Banks (2009, p. 6).
Seoul Central District Court, 2008kahap3816 Preliminary Injunction Decision, December 30, 2008 (hereinafter the “Monami” case).
After the court’s decision was rendered for this case, the media paid widespread attention to cases related to the KIKO contracts. The first court’s decision on KIKO on the merit for a regular case (not a preliminary injunction case) was rendered on February 8, 2010. The court sided with the banks. Seoul Central District Court, 2008gahap108359 Decision & 2009gahap28276 Decision.
yakkwaneui kyujee kwanhan bopryul [Act Concerning Regulation of Standardized Contracts], Law No. 8632.
Korea Fair Trade Commission Press Release, kiko, bulgongjeongyakkwan anida [KIKO is not unfair form contract] (July 25, 2008).
Supreme Court, 2004da31302 Decision, March 29, 2007.
On the rational choice theory, see, e.g., Posner (1998).
Although using economic fundamentals to forecast exchange rates would be conceptually sound, there is evidence that, at least for a short to medium-term period, economic fundamentals often do not have much predictive power. See, for one of the first attempts to report and analyze this phenomenon, Meese and Rogoff (1983). There is also a very different approach, which can be called the technical approach. Under the technical approach, various charts and statistical techniques are used to predict exchange rates based on past exchange market developments. Academic debates have been made and will continue to be made to reconcile the differences between these different approaches and to enhance predictability of exchange rate fluctuations.
de Grawe and Grimaldi (2006, p. 9). Some empirical findings show that the exchange rate may move widely even when there is very little shift in the fundamental values.
The KIKO contract was especially popular during a few months in the second half of 2007 and in January 2008. Lee and Kim (2009, p. 48).
Claim of Kim Sang In, chief executive officer of a Korean construction-equipment maker. See Lim (2008).
Monami case, p. 23.
Ibid.
Of course, if the risk of default and the risk of the contract validity being challenged are also considered, the banks should be considered to have assumed significant risks.
For banks’ contracting schemes to manage their own risk positions, see Lee and Kim (2009, pp. 45–48).
Some observers claim that the main culprit behind the US mortgage crisis was securitization, which created a host of agency problems. The compensation for these agents-intermediaries, who were assigned the role of originating loans, pooling mortgage-backed securities, and assessing the risk associated with the different securities, was not designed to align their interests with those of the principals-investors. Their fees were, for instance, based on the quantity, not quality, of processed loans. As a result, the agents-intermediaries had an incentive to increase the volume, even when it created low-quality, high-risk loans. See Bar-Gill (2009).
Seoul Central District Court, 2009kahap393 Preliminary Injunction Decision, April 24, 2009, p. 9 and p. 19; Seoul Central District Court, 2009kahap207 Preliminary Injunction Decision, April 24, 2009, pp. 7–8.
A similar market situation was observed prior to the US subprime mortgage meltdown, where banks offered complex mortgages that had small down-payment and small short-term monthly payment, but higher monthly payments in the future. See Bar-Gill (2009, p. 31).
Ibid.
This is especially true considering that the pricing of an option is partly based on how much hedging the option offers. Since the KIKO contract offered less hedging, the premium would be naturally cheaper compared to the standard exchange rate hedging options.
Jolls et al. (2000 , p. 13 and 38).
Ibid., p. 47.
This period does not include the period affected by the Asian financial crisis.
In one study, subjects were asked to predict the percentage of African countries in the United Nations. The subjects were given a number between 0 and 100 randomly determined by the wheel of fortune, were asked first if the number was too high or too low, and were asked to estimate the value by adjusting that number. Median estimate for groups that were given by the group that received 10 from the wheel was 25, while median estimate for the group that received 65 from the wheel was 45, although the initial number had nothing to do with the actuality of the question at hand. Tversky and Kahneman (1974).
de Grawe and Grimaldi (2006, p. 9).
Ibid. pp. 13–19.
Ibid. pp. 10–11. In a similar vein, Andrew Lo proposes what is called the Adaptive Market Hypothesis, which reflects an attempt to reconcile the Efficient Market Hypothesis with the results of behavioral finance. Lo (2005).
de Grawe and Grimaldi (2006, p. 10).
See, for general discussions on issues related to time discounting and time preference, including hyperbolic discounting, Frederick et al. (2004).
Dimson et al., using the US securities market, illustrate how positive memories of investors often influence them to be “irrationally” optimistic. Dimson et al. (2004, pp. 15–16).
Langevoort (2004), p. 93.
Heath and Jourden point out that optimism bias is more pronounced in small groups. Heath and Jourden (1997, p. 103).
Kuran and Sunstein (1999).
Ibid.; Sunstein (2003, pp. 54–74).
Shiller (1995, p. 181).
Fiol and O’Connor (2003, pp. 67–68).
Banerjee (1992, p. 798).
This in turn would mean that, to have a meaningful impact on the companies’ decision-making process, disclosure and explanation would take place at the earliest possible opportunity, if at all possible prior to the time when they form their expectations. Once these companies have preconceived expectations, banks’ role may need to include inducing them to break the existing expectations, which could sometimes be an exceedingly cumbersome procedure.
Examples of government’s direct intervention would include directly setting limits on the amount of losses that an individual contract buyer can assume. Detailed discussion on the desirability or policy implications of this type of direct intervention is beyond the scope of this article.
This is a main lesson of the prospect theory. Tversky and Kahneman (1981).
Based on the Roman law doctrine of Pacta Sunt Servanda, these proponents believe that invalidating KIKO contracts would threaten the very integrity of contract law in Korea.
This prescription is consistent with court rulings in some of the KIKO cases. In these cases, the courts have ruled that the banks selling derivative financial products should assume a high standard of fiduciary duty to the customer, giving them a mandate to provide information that would cater to the needs of the buyer. See, for instance, Seoul Central District Court, 2009kahap393 Preliminary Injunction Decision, April 24, 2009, pp. 17–23.
In the Monami case, it appears that the knock-in and knock-out parts of the KIKO contract were not properly explained to the buyer and instead the bank only described what would happen if the exchange rate moved with the narrow range of 60–70 Won. Monami case, p. 23.
There are several unresolved issues in this context. First, it is not clear if most companies would participate “voluntarily.” Second, there should be careful observation and analysis as to whether it would be enough to share information or whether more explicit and clear regulation would be needed, e.g., in the form of setting the upper limit in the contract amount that an individual company can hedge or speculate. Third, whether, if the privacy concern is indeed a serious and legitimate one, some other alternatives should be sought other than an information-sharing scheme. One alternative would be to reflect the companies’ position in the representations and warranties part of the contract and, that way, to induce the companies to be forthcoming in some indirect manner. Detailed discussion of these issues is beyond the scope of this article.
Even in the most immediate sense, forcing the firms to go bankrupt could yield an inferior outcome compared to modification, since banks will face difficulties recovering against bankrupt firms.
This appears to have been the case in some court proceedings, Seo (2009).
Holmes ( 1897 p. 458).
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Acknowledgments
We thank Professor Richard R.W. Brooks of Yale Law School for sharing his invaluable insights. We also thank Professor Sangwon Suh and other seminar participants of the Institutions and National Competitiveness Conference, held in August 2009 in Seoul, Korea, for their helpful comments. Geary Choi and Joanne Koo provided excellent research assistance. David L. Simons provided superb editorial assistance. Ko’s research for this article was supported by the Law Research Institute at Seoul National University School of Law. This article was prepared while Moon was with the Center for International Economic & Business Law, Seoul National University.
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Ko, H., Moon, W.J. Contracting foreign exchange rate risks: a behavioral law and economics perspective on KIKO forward contracts. Eur J Law Econ 34, 391–412 (2012). https://doi.org/10.1007/s10657-010-9204-9
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DOI: https://doi.org/10.1007/s10657-010-9204-9