Hedge Management

Dec 06, 2008 (LBO) – The Sri Lanka unit of the Indian Oil Corporation has unwound some oil derivatives it bought earlier in 2008, but is left with 70,000 barrels worth deals that will expire next year, a top official said. Lanka IOC says it is honoring all contracts.

Exotic Derivatives

Lanka IOC had bought protection in consultation with banks by paying a premium, though oil prices have now fallen further.

CPC however had no permission to pay premiums, because it was limited by the cabinet to ‘zero-cost’ instruments.

In Sri Lanka, banks have been blamed for selling a complex product with no downside protection or a ‘knockout’. But the derivative is based on a structure used in securities markets known as a target accrual redemption note (TARN).

They are also known as leveraged target redemption forwards or swaps. The attraction for an oil distributor was that it was ‘zero-cost’, or no payment was involved. But it got ‘knocked out’ after accumulating about five dollars a month a barrel for three months.

Under a ‘zero-cost’ structure, the oil distributor wrote an option, earned a premium and used it to buy an option giving upside protection.

The upside risk was capped for taking