International Law

That possibility arises from a fundamental tenet of international law that is not written down in any law book: In extremis, the locals win.

—“Bad Trades, Except in Korea,” by Floyd Norris, The New York Times, April 2, 2009.

South Korean exporters in 2006, 2007, and into 2008 were not particularly happy with exchange rate trends. The South Korean won (KRW) had been appreciating, slowly but steadily, for years against the U.S. dollar. This was a major problem for Korean manufacturers, as much of their sales were exports to buyers paying in U.S. dollars. As the dollar continued to weaken, each dollar resulted in fewer and fewer Korean won—and nearly all of their costs were in Korean won. Korean banks, in an effort to service these hedging needs, began the sale and promotion of Knock-In Knock-Out option agreements (KiKos).

Knock-In Knock-Outs (KiKos)
Many South Korean manufacturers had suffered falling margins on sales for years. Already operating in highly competitive markets, the appreciation of the won had cut further and further into their margins after currency settlement. As seen in Exhibit A, the won had traded in a narrow range for years. But that was little comfort as the difference between KRW 1,000 and KRW 930 to the dollar was a big chunk of margin.

Exhibit A South Korean Won’s Steady Appreciation
Figure A Full Alternative Text
South Korean banks had started promoting KiKos as a way of managing this currency risk. The Knock-In Knock-Out (KiKo) was a complex option structure, which combined the sale of call options on the KRW (the knock-in component) and the purchase of put options on the USD (the knock-out component). These structures then established the trading range seen in Exhibit A that the banks and exporters believed that the won would stay within. Korean companies were repeatedly assured by the bankers selling the structures that there was nearly a 100% certainty of the Korean won remaining within the trading range for the year.

But that was not the entirety of the KiKo structure. The bottom of the range, essentially a protective put on the dollar, assured the exporter of being able to sell dollars at a set rate if the won did indeed continue to appreciate. This strike rate was set close to the current market and was therefore quite expensive. In order to finance that purchase, the sale of calls on the knock-in rate was a multiple (sometimes call the turbo feature), meaning that the exporter sold call options on a multiple, sometimes two or three times, the amount of the currency exposure. The exporters were “over-hedged.” This multiple yielded higher earnings on the call options that financed the purchased puts and provided added funds to be contributed to the final KiKo feature. This final feature was that the KiKo assured the exporter a single “better-than-market-rate” on the exchange of dollars for won as long as the exchange rate stayed within the bounds. Thus, the combined structure allowed the South Korean exporters to continue to exchange dollars for won at a rate like


USD when the spot market rate might have only been KRW 910.

This was not, however, a “locked-in rate.” The exchange rate had to stay within the upper and lower bounds to reap the higher “guaranteed” exchange rate. If the spot rate moved dramatically below the knock-out rate, the knock-out feature would cancel the agreement. This was particularly troublesome because this was the very range in which the exporters needed protection. On the upper side—the knock-in feature—if the spot rate moved above the knock-in rate, the exporter was required to deliver the dollars to the bank at that specific rate, although movement in this direction was actually in the exporter’s favor. And the potential costs of the knock-in position were essentially unlimited, as a multiple of the exposure had been sold, putting the exporter into a purely speculative position.

2008 and Financial Crisis
It did not take long for everything to go amiss. In the spring of 2008, the won started falling—rapidly—against the U.S. dollar. As illustrated by Exhibit B, the spot exchange rate of the won quickly blew through the typical upper knock-in rate boundary. By March 2008, the won was trading at over KRW 1,000 to the dollar. The knock-in call options sold were exercised against the Korean manufacturers. Losses were enormous. By the end of August, days before the financial crisis broke in the United States, it was estimated there were already more than KRW 1.7 trillion (USD 1.67 billion) in losses by Korean exporters on the KIKOs. An exchange rate movement which should have been good for exporters was now generating massive losses.

Exhibit B South Korean Won’s Fall and the Knock-In
Figure B Full Alternative Text
Caveat Emptor (Buyer Beware)
The magnitude of losses quickly resulted in the filing of hundreds of lawsuits in Korean courts. Korean manufacturers who had purchased the KiKos sued the Korean banks to avoid the payment of losses, which in many cases would bankrupt the companies.

Exporters argued that the Korean banks had sold them complex products, which they did not understand. The lack of understanding was on at least two different levels. First, many of the KiKo contracts were only in English, and many Korean buyers did not understand English. The reason they were in English was that the KiKos were not originally constructed by the Korean banks. They were created by a number of major Western hedge funds that then sold the products through the Korean banks, the Korean banks earning more and more fees for selling more and more KiKos. The Korean banks, however, were responsible for payment on the KiKos; if the exporting companies did not or could not pay up, the banks would have to pay.

Secondly, exporters argued that the risks associated with the KiKos, particularly the knock-in risks of multiple notional principals to the underlying exposures, were not adequately explained to them. The exporters argued that the Korean banks had a duty to adequately explain to them the risks—and even more importantly—only sell them products that were suitable for their needs. (Under U.S. law this would be termed a fiduciary responsibility.) The Korean banks argued that they had no such specific duty, and regardless, they had explained the risks sufficiently. The banks argued that this was not a case of an unsophisticated buyer not understanding a complex product; both buyer and seller were sufficiently sophisticated to understand the intricate workings and risks of these structures.

The banks had, in fact, explained in significant detail how the exporters could close out their positions and then limit the losses, but the exporters had chosen not to do so. In the end the Korean courts found in favor of the exporters in some cases, in favor of the banks in others. One principle that the courts followed was that the exporters found themselves in “changed circumstances” in which the change in the spot exchange rate was unforeseeable, and the losses resulting too great. But some firms lost heavily, for example, GM Daewoo lost $1.11 billion. Some Korean banks suffered significant losses as well and may have, in fact, helped transmit the financial crisis of 2008 from the United States and the European Union to many of the world’s emerging markets.

Mini-Case Questions
What were the expectations—and the fears—of the South Korean exporting firms that purchased the KiKos?

What is the responsibility of a bank that is offering and promoting these derivative products to its customers? Does it have some duty to protect their interests? Who do you think was at fault in this 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 clients?


Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2018). Multinational Business Finance (15th ed.). Pearson Education (US).

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