Case Analysis Of CITIC Pacific Loss In KODA

With the development of modern financial derivatives, the financial risk is diversity. Many enterprises run for hedging and they hedge over-the-counter market (OTC market) by purchasing options and swapping. But due to the complexity of the OTC market rules which increase the difficulty of financial derivatives deal and the volatility of derivatives market. Great changes have taken place in the financial market over the world, since the financial crisis broke out. Many financial derivatives enterprises were hit, especially the large losses of CITIC Pacific invested in KODA products.The world financial derivatives market turbulence, resulted from subprime mortgage crisis in 2008. Leveraged KODA is the most representative. The crisis caused a large number of law suits in Hong Kong Financial Market at that time. Most of the damaged investors were form the large listed companies, such as the bankruptcy of HungHing Printing Group Limited and the losses of Shenzhen Nan Shan Power company. The losses of CITIC Pacific invested in KODA has caused a stir. October 20.2008, the CITIC Pacific made a loss of HKS15.5 billion and the loss may widened for the investment of high leverages financial derivatives. Some of the top managers have resigned one after another. The parent company China CITIC Group failed to save CITIC Pacific from the loss.So, KODA as a financial derivative, how did it cause such a big storm to made the CITIC Pacific lose heavily? KODA, accumulator and jokingly called "I will kill you later" in Hong Kong is a new option products to meet the demand of holding other companies’stocks. The objects include:stock, foreign exchange and product. KODA has four main features:discount, cumulative purchase and leverage, which increase the complexity of KODA transaction. In 2005,the KODA products kicked off with the USA FC Stone company’s first use in crop market.This paper takes the CITIC Pacific as an example which lost heavily by investing financial derivatives in the financial crisis. First, Citic Pacific is a state-owned company, it has common problems in the internal management mechanism just like other state-owned enterprises;Second, KODA is a typical OTC derivatives.the OTC derivatives market is more flexible and free than the floor Trading market, and the supervision and restriction of the OTC derivatives market is relatively small.Correspondingly, the quality requirements of traders are higher, but also contains a higher risk.These characteristics for OTC derivatives markets has created such losses in the event of "incident-packed parts". In which the KODA contracts is in the subprime mortgage crisis caused by a large number of individuals and corporate investors suffered huge losses, also including a number of large state-owned enterprises.Therefore, This paper based on the analysis of the typical case of CITIC KODA transactions,and the KODA contracts signed by CITIC Pacific as the foundation of analysis, from the parties face to research and analyze the cause of the loss, can be summed up some useful experience and lessons,which could be used to our country state-owned enterprises in the use of the international derivatives market for hedging, or from the internal control mechanism should be how to prevent the problems of wrong operation.During the analysis, the paper first introduces the KODA meaning features and option pricing methods of KODA to provide the theory support for the case analysis. Then,giving a detailed account of the loss from contract signing, loss process and settlement of loss. By detailed analyzing a series of accumulator contracts between CITIC Pacific and 13 foreign banks from two aspects:the treaty contents and the rationality of contract signing. At last get some suggestions according to the above analysis.Generally speaking, the contracts fall into four main groups:Australian Dollar(AUD),Daily Australian Dollar, Dual currency and RMB contract. This paper focus on analyzing AUD contract, which is the largest proportion. According to the KODA’s characteristics, we can regard AUD as a combined option, one is barrier call options; another is European put options. In the analysis of the contract signing, we inconsiderate to option premium, by drawing the profit and loss statement of buying in one call option and selling out 2.5put options. We find the contract auto ended for the existence of knock out price when the AUD rising. The CITIC Pacific’s profit is limited, but it got large loss, when the AUD falling. These show the contract can’t hedge well.Then, by analyzing the price in the contract to provide that:inconsiderate to hedging, the Purpose of speculation, the contracts also lacks fairness. This paper use the up-and-out call and Black-Scholes(BS) models to calculates and compares the cost of CITIC buying in one call option and the income of 2.5 put options from the bank, the contract term is two-year in data processing, so this paper choose the closing price of Daily AUD for USA Dollar between July,l,2006and June,30,2008.Taking the US two-year Treasury yield as risk free rate of interest, then use up-and-out call to get the call option price and BS option valuation to get the price of put options. The results show that:one price of call option is smaller than 2.5 put options. CITIC Pacific should get the positive cash in flow, but it didn’t. This show the contract is unfair and CITIC Pacific at a disadvantage.So what is the reason caused the unreasonable and unfair contract to be signed?Next, this paper will combine the above contracts analysis to system analysis the cause of CITIC Pacific’s big losses.This paper will be carried out from two aspects of surface and deep to discuss the reason for the loss.To a certain extent,the Australian dollar exchange rate lower, but the dollar higher lead the citic Pacific to financial crisis. Greater exposure, improper selection and counterparty financial instruments fraud makes CITIC Pacific at a disadvantage.But this is only the surface layer of reasons behind the loss. The deeper reasons include the followings:One is the that citic group as a controlling share holder did not give full play to its supervision and decision-making. Although the CITIC Group in the absolute holding status, but due to there is no fully use its supervision and decision-making power, low in CITIC Pacific board decision-making;Second is the lack of oversight functions of the board of directors, the astronomical salary system in a certain extent induced business decision to take more aggressive investment strategy, to bring huge risk, and company director regulation is not in place, eventually leading to CITIC Pacific unfortunate occurrence;Three is excessive concentration of power, the company "family", which can lead to company’s business decision-making power imbalance, influence company; risk management; Fourth, risk management mechanism is not sound. Financial risk management department and the lack of professional risk management reflects the citic Pacific risk supervision and governance mechanism is not perfect; Five is the lack of a clear business authorization process, exposed the citic Pacific internal authorization and the lack of separation mechanism.Finally, combining the contract with the analysis of the reasons for the loss, this paper will recommendations corresponding revelation from the following several aspects:One is to strengthen the internal oversight. To carry out the duties, establish a set of scientific compensation system, and strengthen the establishment of the mechanism of information disclosure; Second is to strengthen risk management.Establishing a risk aversion based investment philosophy,enhancing the awareness of exchange rate risk management,seting up the risk management department, establishing risk control mechanism,improving the level of professional knowledge inrisk management,absorbingthe international professional financial talent; Three is to enhance the ability to read about market movements. Enterprises should actively participate in the international financial derivatives market; Four is prudent to deal with financial derivatives. Adhere to hedging principle, in the choice of financial derivatives, should choose to comply with the hedging objectives of the most simple, the most commonly used financial derivatives, clear goals, constantly maintain a cautious attitude, avoid into the orbit of speculation.