An importer with large dollar debts sold your bank USD 50 million one year forward at 84. The rupee falls to 92. What does the client owe, why is that exposure likely to go bad at exactly that moment, and how do you protect the bank?

Pavagad owes the bank about Rs 40 crore, and the exposure is wrong-way because the move that creates it is the move that weakens the client. At 92 the client must deliver USD 50 million worth Rs 460 crore for Rs 420 crore. At the same time its USD 300 million of debt has grown by Rs 240 crore in rupee terms and its interest bill by Rs 17 crore. Protect the next trade with a collateral agreement, a line sized for the correlation, and a check that the forward hedges an exposure rather than adding one.

Start with the mechanics, because the direction is where people slip. Pavagad sold dollars forward: it promised to deliver USD 50 million and receive Rs 84 for each. At 92 the dollars it must deliver are worth Rs 460 crore and it receives Rs 420 crore, so the forward is a Rs 40 crore liability for the client and a Rs 40 crore claim for the bank. Had the rupee strengthened to 80 the signs would flip and the bank would owe Rs 20 crore. A forward is a two-way promise, and the bank's credit exposure is whichever side it happens to be owed, which is why it is not fixed at inception.

Lending an umbrella to a neighbour is fine; lending it on condition that he returns it only when it rains is not, because the day you need it back is the day he will not give it up. Wrong-way riskCredit exposure that grows at the same time as the counterparty becomes more likely to default, because both are driven by the same market move. is exposure that rises precisely when the counterparty's ability to pay falls, and a dollar borrower selling dollars forward is the textbook case. The rupee's fall to 92 does three things to Pavagad at once: it creates the Rs 40 crore forward loss, it lifts the rupee value of its USD 300 million debt from Rs 2,520 crore to Rs 2,760 crore, and it raises its dollar interest and import costs. Net debt to EBITDA, counting the forward, goes from about 5.0 times to 5.6 times. The bank's claim is largest at the moment the client's lenders are already nervous.

Four changes, in the order a credit committee would take them. First, a collateral agreement with daily variation margin and a threshold sized to the client's unsecured capacity, so the claim is funded as it grows rather than discovered at maturity. Second, a credit line for the trade that uses a stressed exposure, say the loss at a rupee move two standard deviations against the client, and adds a wrong-way charge rather than treating the forward as a normal receivable. Third, and most important, ask what the forward hedges: an importer selling dollars forward is adding to its dollar exposure, not reducing it, and a trade that doubles a client's existing risk should be priced and limited as a position, not a hedge. The rules on forwards being backed by an underlying exposure should be confirmed before any such trade. Fourth, offer the structure that fits: buying dollars forward, or a bought option, which would have paid the client at 92. The limit of all this is that collateral only helps if the client has liquid assets to post, and a refiner with rising import bills may not; the real protection is the line size.