Case Study: KIKO Derivatives and the South Korean Won Crisis

This case study examines the KIKO derivatives crisis in South Korea, focusing on the losses incurred by exporters due to the depreciation of the Korean Won (KRW) against the US dollar. The analysis explores the roles of various stakeholders, including banks, exporters, and the government, and assesses their responsibilities and ethical considerations. The study highlights the problems arising from complex financial products, lack of understanding of contract terms, and inadequate risk assessment. It delves into the economic impacts on the balance of trade and offers lessons for firms using foreign currency derivative products. The paper also discusses the ethical issues related to the banks' marketing practices and the government's intervention, as well as the economic effects on the balance of trade. The case underscores the importance of informed decision-making, understanding financial contracts, and the need for ethical conduct in financial transactions. The paper draws conclusions about the need for transparency, proper risk management, and the limitations of government intervention in financial markets.

Running head: KIKO CASE ANALYSIS 1
The South Korean Won and the KIKO
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KIKO CASE ANALYSIS 2
Introduction
Speculation can potentially stabilize or destabilize a market. Speculation that is not
informed will effectively be destabilizing, as opposed to informed speculation that will be
stabilizing. Markets get liquidity and will be in equilibrium swiftly if traders use informed
speculation. According to Hayward (2018), a core role played by speculation is the stabilizing of
markets and provision of equilibrium in financial market transactions. Speculation achieves this
by the provision of liquidity in allowing all market participants and hedgers to swiftly adjust
without huge price concessions. Tornell & Yuan (2011) argue that futures markets are useful in
helping producers and farmers in transferring commodity price risk by the employment of
hedging strategies and facilitation of other market participants. They do this by the use of
relevant futures information in forecasting the future prices and then attempt to reap from huge
profits.
Key problems and issues in the case
When South Korean exporters invested in foreign currency futures, there were several
problems. First, they did not fully understand the complex products that were drafted in English,
a language they did not understand. Additionally, the banks did not sufficiently explain to them
the risks associated with the products as the banks didn’t act in the best interest of the exporters.
Thesis statement
South Korean exporters were not well-informed when they bought Knock-In Knock-Outs
(KIKOs) and they, therefore, incurred enormous losses when the Korean Won (KRW) fell
against the US dollar in the spring, 2008.

KIKO CASE ANALYSIS 3
Stakeholders involved in the case
There are several stakeholders who were involved and affected in the case. These were the
banks, the exporters and the government.
The expectations—and the fears—of the South Korean exporting firms
The South Korean exporting firms expected protection against loses emanating from more
appreciation of the KRW. They feared that the KRW would continue to appreciate against the
dollar, making them lose more money.
Responsibility banks offering and promoting these derivatives
The bank offering such derivatives to customers had a responsibility to clearly explain the risks
of the contracts to the customers alongside the benefits. The banks had some responsibility to
protect the customers through fiduciary law. The banks were at fault since they failed to provide
this information.
Government’s obligation to intervene
Although a government cannot sit and watch as its citizenry is being exploited by unscrupulous
investors, the South Korean government had to practice restraint in navigating the issue. It did
not have any obligation to intervene since this would interfere with freedom of contracts. The
government could have provided guidelines but not usurping authority over the stakeholders.
The case and the balance of trade
The case affected the balance of trade since it interfered with exports and imports. Due to the
losses incurred by the traders, they were no longer able to export as much as they would initially
due to diminished resources.
Lessons drawn from the case
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?

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I would bring to attention the following lessons:
- KIKO buyers have a responsibility to understand the contracts before they buy the
products.
- Traders should not depend on the government for bailout from failed transactions.
- Investors who fail in their fiduciary responsibility should face legal action.
- The government should refrain from interference with free trade.
The Background of the South Korean Won and the KIKO
From 1997, the KRW depreciated sharply at the wake of the Asian currency crisis. This
depreciation continued to early 1998, only to start gradually appreciating until late 2007. This
was attributed to the enormous size of capital inflows and current account surplus in Korea.
Consequently, many Korean exporters responded by trying to hedge the rate of exchange
regarding their foreign currency revenues (CFTC, 2012). The option that was readily available
for them was the KIKO option. During this period, this was not a new concept since it was
widely used in Korean markets (CFTC, 2012). Some commercial banks aggressively persuaded
their customers to make use of the KIKO option for their hedging purposes (Eiteman, Stonehill,
& Moffett, 2015). The assumption was that the KIKO option would grant positive payoffs to the
holders if the KRW appreciated moderately to predetermined levels. On the other hand, the
holder would expect negative payoffs if the KRW significantly depreciated.
In the summer of 2008, the KRW reversed its direction unexpectedly and was on a steady
depreciation trend. The acceleration of the depreciation was high as this was during the global
financial turmoil. Within a short while, the KRW traded at over 1000 against the dollar, forcing
the South Korean banks to exercise the knock-in call on the manufacturers. Consequently, the

KIKO CASE ANALYSIS 5
exporters reported huge loses that was in the tune of millions of dollars. The KIKO holders face
accumulated loses without any hope of reversal. Although there were litigations against the
South Korean Banks, it was hard for the courts to take a standard stand on the issue but dealt
with the cases on an individual basis. This saw some banks incurring losses and some exporters
incurring loses as well.
The scenario presented several issues. The banks appeared to have exploited the
ignorance of the exporters by taking advantage of their inability to understand the contracts
which were drafted in English, a language that was alien to the exporters (Tang & Wei, 2012).
The banks did not do this in futility since there was much money to be reaped from the sellers of
the KIKOs they brokered for. The banks earned more money when they sold more KIKOs.
Consequently, they proactively persuaded their clients to use the KIKO option. Additionally, the
fact that the banks did not fully explain the significance of the KIKOs and the real risks
associated with them is questionable. The banks are presented as selfish entities that acted on
their best interests and not on the best interest of their clients (Baker & Wurgler, 2017). The
complexity of the KIKO arrangement did not help the situation. It was essential for the parties
involved to fully understand the consequences of any eventualities emanating from their
investment decisions. Additionally, it is apparent that the KIKOs were not well designed for
hedging needs of the customers. The structure of the KIKOs was that they would cushion the
exporters if the KRW only appreciates moderately. On the other hand, if there was a sharp KRW
depreciation, KIKO holders would incur financial loses. Lack of proper financial advice from the
financial banks made the situation worse for the exporters (Khil & Suh, 2010).

KIKO CASE ANALYSIS 6
Ethical Considerations regarding the South Korean Won and the KIKO
a. Exporters
It is important to note that KIKO buyers were able to realize short term profits. There
were prevalent cases of moral hazards whereby some exporters entered into the contracts simply
because their competitors had bought the KIKOs. It is not unreasonable to consider the fact that
most of these KIKO buyers bet on the possibility of a government bailout. This is due to the
importance that the government attached to exports (BIS, 2016). Some researchers like Chelley-
Steeley, Patricia, & Nikos (2013) argue that there are many exporters who entered into the
contracts with diverse banks without any justification to do so while others bought KIKOs worth
much more than their projectable income from overseas. Therefore, the courts cannot be seen as
to have been justified in their forceful intervention. If anything, all that can be realized from such
intervention is increased dependency on government intervention when all goes ill in business
transactions. This is because both parties apparently enjoyed the arrangement up to 2008 when
things went in the opposite direction. This is an act that can be precedent to many litigations in
the future when businessmen carelessly enter into contracts. Additionally, it is questionable how
the exporters entered into contracts that were drafted in English when it is clear that they could
barely understand English (Eiteman et al., 2015). Apparently, greed was the driving force in all
this as the bank marketed the products.
b. Banks
There are questions regarding how the South Korean banks conducted themselves in the
selling of the KIKOs. Understandably, the banks were paid on a commission basis. This means
that they had to sell more to gain more. This scenario describes a state where the banks had to

KIKO CASE ANALYSIS 7
ensure that they sold quantity as opposed to quality. Apparently, the banks did not have enough
time to explain to the clients the real issues behind the contracts since they were in the pursuit of
the next available customer. More customers meant more money for the banks. This was an
egocentric approach on part of the banks and an exploitative approach by the foreign owners of
the KIKOs.
The banks failed to adhere to international standards of fiduciary duties. As their
obligation, the banks were supposed to act in protection of the interests of the clients. This was
not the case since the banks looked only at the monetary gain that they would reap from the
contracts. In the process, the need to carefully consider the interests of the client faded into
insignificance. This was a violation of the rights of the customers and deserved a legal redress. A
bank that only looks at the benefits that it will reap from the clients is not worth to be in the
industry (Summers, Hillman, & Hoffman, 2016). In one instance, one CEO said that the banks
didn’t notify the customers of the risks but said that they were 99% confident that the won was to
continue rising. All that the banks highlighted were the rosy sides of the contracts without any
attempt to present the dark side of the deal. These were merely marketing gimmicks.
c. The government
Another ethical issue is connected to the courts. When the exporters presented their cases
to the courts, many courts ruled in their favour. This did not spare the Korean Supreme Court.
Although this was a good thing for the exporters who were financially ailing, it is not good for
business (Yan & Shu, 2011). The courts forcibly stepped in and intervened. These were acts of
infringing on the freedom of contract. In every free enterprise system, freedom of contract is an
inevitable tenet. When the freedom of individual contract is respected, it is a way of safeguarding
the exchange of services and goods in any free market arrangement. It is a requirement in public

KIKO CASE ANALYSIS 8
policy that adults who have competent understanding are granted the liberty to enter into
contracts and that their contracts are sacred, as long as they were entered in a voluntary and free
manner.
Is such outright judicial intervention desirable? For courts to step in, they step on the
freedom of contract. Freedom of contract is a practical principle that is the inevitable counterpart
of a free enterprise system because respecting individual contracts safeguards the exchange of
goods and services on the free market (Hellbeck, 2010). The courts have got no grounds in law
to intervene in situations that cannot sufficiently prove that the contract was entered by coercion.
In such cases, there needs to be enough evidence that the agreement is adequately one-sided.
Unfortunately, it is not easy for courts to make a clear distinction between unfair coercion and
lawful market pressure. Consequently, the courts should not intervene save in situations where it
is the last resort. This should only be enforced in extreme cases where there are no other
available means of intervention that can avail (Killeen, Lyons, Moore, 2016).
Economic Effect of the South Korean Won and the KIKO
a. The balance of trade
The balance of trade was negatively impacted. This saw lesser exports to overseas
countries since there was little to gain from the transactions. Additionally, the exporters were
battling massive sales and they had to recuperate from the loss for some time. Therefore, it took
sometime before they could recover from financial problems (Evans & Lyons, 2016).
b. Other economic effects
The entire issue affected trade as a whole in South Korea. The huge loses that were
inured negatively impacted on the GDP. Some businesses went into bankruptcy while others

KIKO CASE ANALYSIS 9
could barely stay afloat. There are other businesses like banks that opted to close as they
considered the intervention by the government as unfair and unwarranted.
Recommendations
a. Solution and strategies for accomplishing it
Although the government cannot sit idly as its citizenry are exploited by banks and other
unscrupulous investors, it is essential that the government steers away from interfering with
private contracts. The government can achieve this by ensuring that there are clear cut policies
that govern foreign currency futures contracts. These policies must be regarded as binding and
the citizenry should not revert to the courts when they are on the wrong (Roon, Nijman, & Veld,
2010).
Banks should be held accountable for fiduciary responsibility and should not be allowed to
violate this requirement. If proven that there was a breach of this core tenet, a tough judgment
should be passed and penalties imposed (Hongjun, 2009).
b. Further action to resolve some of the issues
The banks should own up to the fact that they didn’t explain the contracts to the exporters.
Additionally, exporters should not be allowed to exploit the banks in compensation since they
initially benefitted from the trade. Therefore, both parties should bear their own costs.
c. What should be done and by who
In the future, the government should practice refrain in interference with free contracts, the banks
should ensure dissemination of appropriate information to the customers and the customers
should not enter into contracts without properly understanding the risks associated with them.

KIKO CASE ANALYSIS 10
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