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P. V. Maiya

This book captures the explosive growth of derivatives and the acute need for appreciation and management of risks in a thematically integrated manner. First published in August 1994, this is the fourth edition.

The contents are divided into four sections: Foreign Exchange, International Finance, Derivatives, and Risk Management. A number of annexures highlight concepts, issues and events mentioned in the main text. The book is peppered with quotes and references for those inclined to study further.

The book opens with a summary of developments in the last six decades in international financial markets, beginning with Bretton Woods, the role of institutions like the World Bank and IMF, collapse of the fixed exchange rate regime, birth of the Euro, growth of the developed countries' clubs and so on. The book goes on to explain various facets of international and Indian foreign exchange markets, exchange arithmetics, the trading and communication systems used and so on. The chapter on `International foreign market: Exchange rate movement' reveals interesting facts: More than 90 per cent of market transactions are speculative; no study has succeeded in predicting exchange rate volatility; and economic fundamentals do not have any decipherable relationship with the exchange rate movement. External trade and foreign exchange might be tenuously related, yet an annexure on foreign trade and documents would have made for a complete handbook.

The chapters on international finance survey finance from sources like the World Bank, ADB and IMF through bilateral arrangements between governments and through the issue of equity and debts in the international capital markets. The emergence of floating interest rates such as LIBOR, which helped transform 3-6 month offshore funds into loanable, medium-term resources is well explained.

The author makes a case for supplementing domestic savings with international finance to ensure sustained growth. This is counter-balanced with checks to avert balance of payment crises. The experiences of Latin American and East Asian countries in the 1980s and 1990s are cited to throw light on the consequences of reckless borrowing and, contrarily, imprudent lending. Distilled from these experiences is asage counsel: "Overvalued currencies, unsustainable current account deficits financed by short-term capital flows and a liberal capital account are a dangerous combination!"

Derivatives — a much-maligned subject thanks to several infamous cases — is succinctly outlined in the last chapter. Almost all the end users have sued banks that sold the deals on grounds of inadequately explained risks and/or outright chicanery.

While Warren Buffet, the bete noire of many corporates, considers derivatives to be financial WMD (weapons of mass destruction), Alan Greenspan thinks such financial innovations are good for the global economy. Surprisingly none of the cases, barring the untested case of LTCM, which was rescued by the Federal Reserve, led to market meltdown. It could be argued that the market bore the risks, validating the purpose of derivatives, which is to transfer price risks from a party unwilling to carry to a party willing to accept it.

Derivative instruments are, in substance, forwards, options and swaps traded in exchanges with little counter-party risk, or OTC (over the counter) with counter-party risk. In the two decades since the advent of floating exchange rates, the market has seen a variety of instruments — from plain vanilla to the most complex ones — to manage risks of volatility. The author has explained all derivatives, their documentation and accounting system, with pithy and insightful comments. For Indian corporates and banks, Accounting Standard 11, which could dent their profits owing to the translation effect of foreign currency borrowings, is relevant for hedging.

The section on risk management deals with the types of risks faced by banks and the measures needed to identify, quantify and control them. These are easy to read but not meticulously practised. Non-observance of basic tenets like separation of front office and back office, and vigilance against high-flying dealers and exotic deals have devastated people and institutions, a la Barings.

With his extensive knowledge and experience as a banker, financial consultant and columnist, Rajwade has done a yeoman service to bankers and academicians in bringing out this book. It is a must-read for board directors ... if they swear by corporate governance.

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