Analysis of Currency Derivatives in Law and Economics

The importance of currency derivative contracts, entered into in order to hedge foreign exchange related risks, cannot be exaggerated. As a global trade regime is emerging, those who engage in international trade are affected by fluctuations in the forex markets more than ever before. Currency risk hedging is also closely related to the process of hedging risks in the commodity market. The market of currency hedging today runs into tens of trillions of dollars. While currency derivative contracts have steadily become a very important component of the process of globalisation of trade, these instruments are looked upon with suspicion as well. Though derivatives seem to be unavoidable, there have been legal and socio-political controversies over these contracts. A whole lot of currency derivative contracts around the world, and specifically in India, have been challenged as wagering contracts. If a derivative contract is entered into with a speculative purpose, it will be a wagering contract. What is the boundary that distinguishes hedging of genuine risk from speculation? It is proposed that the discipline of Law and Economics can provide useful insights and develop a test that can tell apart hedging from speculation. For creating a legal certainty that can facilitate a growth of the currency derivative market which is acceptable socially and in financial quarters, one must also address the possibility of elimination of risk post contract, but before the derivative contract materialises. Behavioural economics can be used to predict the actions of counterparties in a currency derivative contract in the face of possibility of risk elimination post contract. Should such elimination render a derivative contract into a wagering contract, very interesting behavioural patterns may emerge in the currency derivative markets, which will considerably influence international trade. Application of the game theory in this respect provides significant insight into the law making process. Hedging enables those with expertise in a certain business activity to engage in that activity without having to bear more risk than what he is able to handle. The extra corpus of risk can be passed on to a counterparty who is willing to bear such risk through a derivative arrangement. The concept of specialisation would explain that such a person is better equipped to deal with the said risk. On the other hand, through forward or options contract, one determines otherwise unknown costs to be incurred in future. Uncertainty as to value always negatively affects bargaining. It also makes searching for a counterparty for entering into a contract difficult. Removing the uncertainty reduces these transaction costs substantially. We propose that this rationale can be used to come up with better law and policy regarding currency derivative contracts, especially to deal with the derivatives or wager dilemma. This argument also has a far reaching effect on the valuation of a derivative contract. Is the arbitrage, i.e. the difference between the contract price and the market price,(known in financial jargon as asset price) be understood to be the only value of the contract, or should one also take into account the costs that could be avoided by entering into the contract in the first place as well? An attempt to answer this question from a Law and Economics perspective will involve an analysis of the current market practices. The market conditions in which currency derivatives are traded, especially in India, is to be examined and tested from the angle of economic efficiency. This paper was prepared for presentation to the 19th International Conference of the International Trade and Finance Association in Beijing, China, May 27-30, 2009.