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MINISTRY OF EDUCATION & TRAIN NATIONAL ECONOMICS UNIVERSITY -🙞🕮🙜 - FINANCIAL INVESTMENT Topic: How derivatives were used by speculators in the Thailand Financial Crisis of 1997 Prepared by Group – BFI 63 Phạm Hữu Mạnh Trần Xuân Hải Nguyễn Thái Dương Đào Văn Hiếu Phạm Thị Hải Linh Tô Tùng Dương 11213747 11212016 11211597 11212220 11213399 11211639 Table of Contents: I Introduction II Factors leading to the crisis i Economic boom and Overinvestment ii Policy choice: iii Other factors 10 III Persistent Current Account Deficit 10 Lack of efficiency in Financial Institutions’ operations 10 How derivatives were used to make profit for a country following trilemma ( 1997 ) 11 i Short sell 12 Definition .12 Short selling stratery 13 ii Short sell Risks 13 Put option .14 iii Definition .14 Purpose of Put Options .15 Soros Short sell stratery in 1997 .15 Short sell stratery 15 Option stratery 16 IV Conclusion .16 V Reference 16 I Introduction The 1997 Asian Financial Crisis, often referred to as the "Asian Contagion" or the "Asian Crisis," was a major financial crisis that primarily affected several East Asian and Southeast Asian countries It was one of the most significant financial crises of the late 20th century and had widespread economic and political ramifications Within months (from July to October 1997), the baht depreciated by 40%, the Philippine peso also depreciated by 27% while the rupiah lost 40% of its value and the Korean won decreased by 35% compared to the USD This is a serious blow to countries known as "miracle economies" The currency crisis quickly turned into “a twin crisis,” a term coined by economists In essence, the currency plunge and the monetary protection policy response of raising interest rates caused a domestic banking crisis This reality has happened in four countries: Korea, Thailand, Indonesia and Malaysia It is worth noting that the average nominal GDP growth of these four countries in the 7-year period before the crisis exceeded 12%/year Taken together, each country more than doubled its GDP in 1996 from its 1990 level, giving rise to the term “miracle economies” coined by the International Monetary Fund (IMF) Despite that, this growth is not sustainable given the large current account deficit and capital inflows, especially short-term types Because of its widespread influence on major fields such as economics and finance, the 1997 Asian Financial Crisis has always been attractive for students And in this assignment, the way of using derivatives to make profits in that crisis, specifically in Thailand, is the main topic II Factors leading to the crisis In this part, main factors leading to the 1997 crisis in thailand or, in our view, conditions for speculations using derivatives to make profit at that time are divided as follows: - Economic boom and Overinvestment - Policy choice - Other factors i Economic boom and Overinvestment: Embedded in 5-year development plans since the early 1960s, Thailand’s macroeconomic policy has been relatively stable over the past decades despite frequent changes in government Thailand followed a development model like many in Asia and elsewhere, involving a long-term structural shift from agriculture to industry The shift from an import substitution policy to greater emphasis on export promotion was essential for the rapid growth of manufacturing production and exports Nonetheless, the export boom came slightly later with more favorable exchange rate policies and an investor-friendly industrial policy With the right development trajectory, before 1997, Thailand had maintained very high levels of economic growth for years, inflation was under control and their savings and investment were very high ,so the country became attractive because all players in the financial world wanted a piece of this kind of economic miracle However, after 1990, the ICOR rate (incremental capital output ratio) that reflects how efficiently capital is being used to generate additional output of Thailand went down as consequences for too much international capital inflows and lack of high profitable projects Thailand’s ICOR rate https://www.semanticscholar.org/paper/A-revisit-to-the-incremental-capital-output-ratio%3A-TaguchiLowhachai/0f051a4b26baccd8d7c1a359b9d8ac6774cba0a5 Document continues below Discover more from: Financial Auditing 225 documents Go to course 58 ACCA F8 materials for Jun08 session Study system F8AA(Int)RQB-Qs d08 Financial Auditing 100% (7) Bai tap kiem toan tai chinh 16 Financial Auditing 100% (4) Chapter 09 questions - answers 12 Financial Auditing 100% (4) Chapter-17-questions KEY 20 Financial Auditing 88% (8) Format kiểm tc - exercise 10 Financial Auditing 100% (2) Test-Bank-for-Auditing-and-Assurance-Services,-13thEdition-Alvin-A.-Arens Financial Auditing 100% (2) ii Policy choice: With the establishment of the BIBF in 1993, Thai firms could have direct access to international financial markets A notable feature of capital inflows was not only the acceleration of foreign loans but also a rising share of short-term loans, especially portfolio investment, nonresident deposits and trade credits Thailand external debt https://www.macrotrends.net/countries/THA/thailand/external -debt-stock The total foreign debt of Thailand stood at $29 billion in 1990 but jumped to $65 billion in 1994 and further shot up to $92 billion in 1997, mostly incurred by the private sector This is a more- than-threefold increase in seven years The ratio of foreign debt to GDP grew considerably from 34% to 49% and the share of private debt rose from about 60% to around 80% before tapering off to about 73% in 1997 Even more frightening is the fact that these loans were not hedged as the THB was fixed by the monetary authority A high proportion of short-term unhedged dollar loans in Thai foreign debt rendered the economy highly vulnerable to speculative attacks => The liberalization of capital control led to a huge amount of loans of Thailand The second mistake was that the BOT retained a fixed exchange rate regime alongside an open capital account (Siamwalla, 1997) Critics suggested that the BOT should widen the exchange rate band, but this was opposed by interested groups, especially bankers and financiers, who were trapped heavily in dollar debt The BOT officials, in the same vein, pointed to a high level of foreign reserves and sound economic fundamentals as counter-arguments However, they were blind to the fact that such high foreign reserves were largely accounted for by short-term inflows (borrowed reserves), not by the earning capability of Thai exports or overseas investment (earned reserves) The reserves were basically short-term and debt induced reserves with a high degree of volatility Another misstep made by the BOT was its attempt to defend the THB because of its confidence in strong fundamentals In November 1996, February and May 1997, the THB suffered a few rounds of speculative attacks “The reserve depletion from these attacks was hidden from the public by the forward sale of its dollars to support the THB” (Siamwalla, 1997) It was reported that about $23 billion was sold forward in swap transactions to defend the THB The intervention generated a loss of about $8 billion, compared to about $10 billion used by the British government to defend the pound in 1991 => Thailand is over confident about their strong economic fundamentals however most of it come from liability Therefore, they believe that can defend the devaluate of the THB using the foreign reserves which were largely accounted for by shortterm inflows Another error by the BOT was to maintain high interest rates in order to boost domestic savings and counter inflationary pressures Thailand’s interest rate https://www.indexmundi.com/facts/thailand/indicator/FR.INR.RINR The widening interest rate spread attracted further capital inflows of the worst kind – hot money in pursuit of a quick profit As the Thai economy got trapped in huge foreign loans, policy makers were unable to cut the interest rates for fear of igniting a reversal In the aftermath of the July 1997 devaluation of the THB, Thailand was under IMF conditionality which prescribed tight monetary policy with high interest rates in order to prevent severe outflows and avert possible speculative attacks on the THB despite its severe contractionary impacts on the economy => As a result of rapid growth and high interest rates, Thailand and many other East Asian countries received a large inflow of hot money and experienced a dramatic boom in asset prices iii Other factors: Persistent Current Account Deficit 1987-1996 was a period where the Thai economy expanded continuously and the Current Account deficit consistently increased and stood at 14,000 million USD prior to the crisis This was a result of significant decrease in exports in 1996 (where exports only grew by 1.9%, compared to 24.82% the year prior, and was the first significant deterioration in exports since Thailand changed its economic development strategy in 1977 that emphasized production for exports) Thailand’s current account balance Lack of efficiency in Financial Institutions’ operations At the end of 1996, Thailand severely lacked confidence in domestic financial institutions, such that the government had to close down 18 finance companies and commercial banks Afterwards, in March 1997, the Ministry of Finance ordered 10 finance companies to raise capital and on 27 June 1997 closed down 16 finance companies and 42 more finance companies on August, for a total of 58 finance companies The government utilized the Financial Institution Development Fund (FIDF), under the purview of the Bank of Thailand (BOT) to provide support and financial assistance to commercial banks and finance companies once customers 10 were unable to pay off their loans This is particularly true for the real estate sector which faced excess investment relative to market demand and created liquidity problems for commercial banks, with NPLs as high as 52.3% of total real estate credit on May 1999 Excessive NPLs reflected the fact that prior to the crisis, financial institutions’ credit approval process was too loose and didn’t accurately consider project feasibilities or the ability to repay debt Moreover, credit was also given out to friends or individuals with ties to politicians on a wide scale III How derivatives were used to make profit for a country following trilemma ( 1997 ) In 1997, George Soros and his Quantum Fund famously took part in a speculative attack against the Thai baht, which was part of the broader Asian financial crisis that year He used a combination of strategies involving spot market transactions, leverage, and options.to bet against the Thai baht Thai baht was artificially too strong compared to economic fundamental There were bubble burst in stock and real estate markets, high level of NPLs, a significant amount of external debts along with economic slowdown and capital outflow But bank of thailand (BOT) kept Baht pegged to dollar under the fixed exchange rate regime whenever the Baht is too weak, it will sell dollar reserve and buy baht so baht value remained stable at 25 baht per dollar Soros and other hedge funds believed that the Thai baht was overvalued and that the country's currency peg to the U.S dollar was unsustainable given its economic fundamentals They saw an opportunity to profit from a devaluation of the baht by taking a short position, essentially betting that the baht's value would decline Soros advertised Thailand’s problems to investors Soros's Quantum Fund, along with other hedge funds, investors, sold large amounts of Thai baht in the spot foreign exchange market This selling pressure put downward pressure on the baht's value Thailand defended the baht by buying up the surplus baht When Thailand started to 11 run out of dollars, the baht was floated on July 2, 1997 The Baht fell from 1$ for 25 baht in June 1997 to 1$ for 54 baht in January 1998 Exchange rate of Thai Baht i Short sell Definition Short selling is a trading strategy used in financial markets where an investor sells a financial asset (ex: stock, bond, currency) that they not currently own The key idea behind short selling is to profit from the asset ‘s declining price in the future Here's how it works: +, Borrowing the Asset: To engage in a short sale, the investor borrows the asset they intend to sell from another party, typically a brokerage or another investor This borrowed asset is then sold in the market +, Selling the Asset: The investor sells the borrowed asset in the open market, thereby entering a short position They receive cash from the sale, which is credited to their trading account +, Waiting for Price Decline: The short seller hopes that the price of the asset will fall over time If the price does decline, they can buy the asset back at a lower price 12 +, Buying Back the Asset (Covering): To close out the short position, the investor buys the same quantity of the asset they initially borrowed and sold (known as "covering" the short position) They return the borrowed asset to the lender The difference between the sale price and the purchase price, minus any borrowing fees or transaction costs, represents the short seller's profit Short selling stratery Short selling is a strategy that can be used for various purposes, including: Speculation: Traders may short sell an asset if they believe its price will decline If their prediction is correct, they can buy it back at a lower price and profit from the difference Hedging: Investors sometimes use short selling as a hedge against other long positions they hold By shorting a related asset, they can offset potential losses in their long position if the market moves against them Arbitrage: Short selling can be part of arbitrage strategies, where traders exploit price differences between related assets or markets Market Making: Market makers, who provide liquidity in financial markets, may engage in short selling to facilitate trading and balance their positions Short sell Risks It's important to note that short selling carries inherent risks: Unlimited Losses: Unlike buying a long position, where the maximum loss is limited to the amount invested, short selling has theoretically unlimited losses If the price of the asset being shorted rises significantly, the short seller must buy it back at a higher price, incurring losses Borrowing Costs: Borrowing the asset for short selling may involve fees and interest payments, which can eat into potential profits Margin Requirements: Brokers typically require short sellers to maintain a margin account with sufficient funds to cover potential losses If the position 13 moves against the short seller, they may be required to deposit additional funds or close out the position at a loss Regulatory Considerations: Short selling is subject to regulations and may be restricted or prohibited in certain markets or during periods of market volatility ii Put option Definition A put option is a financial contract that gives the holder (buyer) the right, but not the obligation, to sell a specific underlying asset (such as a stock, bond, commodity, or currency) at a predetermined price (the strike price) on or before a specified expiration date Put options are commonly used for hedging against price declines in the underlying asset or for speculative purposes Here are key elements and characteristics of put options: Holder's Right to Sell: The holder of a put option has the right to sell the underlying asset at the strike price This right can be exercised at any time before or on the option's expiration date Seller's Obligation: The seller (writer) of the put option is obligated to buy the underlying asset at the strike price if the holder chooses to exercise the option The seller receives a premium from the holder for taking on this obligation Expiration Date: Put options have a specified expiration date, after which they expire and are no longer valid The holder must decide whether to exercise the option or let it expire worthless before or on this date Strike Price: The strike price is the price at which the holder has the right to sell the underlying asset It is set when the option is created and remains fixed throughout the option's life 14 Premium: The holder of a put option pays a premium to the seller when the option is purchased This premium represents the cost of the option and is determined by various factors, including the current price of the underlying asset, the strike price, the time to expiration, and market volatility Purpose of Put Options: Hedging: Investors and traders use put options to protect their existing long positions (such as stocks) from potential price declines This is known as "portfolio insurance." Speculation: Traders buy put options with the expectation that the price of the underlying asset will decline This allows them to profit from falling prices without owning the asset itself Income Generation: Some investors sell put options as part of income generation strategies, aiming to collect the premium if the options expire worthless Liquidity and Exchanges: Put options are typically traded on organized options exchanges, where they can be bought and sold like other financial instruments The availability and liquidity of put options depend on the underlying asset and the exchange iii Soros Short sell stratery in 1997 Short sell stratery For simplicity, Soros borrow 25 million baht and convert to million dollar at fixed exchange rate (25 baht per dollar) BOT kept selling dollar to Soros until it empty dollar reserve, meaning it can't intervene in FX market to keep baht value fixed anymore So, it had to let go fixed exchange rate regime and let the Baht value float according to demand and supply Baht weakened to 50 baht per dollar as nobody wanted baht 15 Soros sold 0.5 million dollar for 25 million baht and repay Baht loan He kept another 0.5 million dollar for himself Option stratery Soros used options contracts to further increase his exposure to the baht's depreciation In this case, Soros bought put options on the baht, which gave him the right to sell the baht at a rate of 26 baht per dollar in the future settlement date of January 1998 Soros traded billion dollars for 54 billion baht on the spot market; he then used his put option to change the 54 billion baht into billion dollars (at the agreed rate of 26 Baht per Dollar) – doubling his money Soros and his Quantum Fund profited immensely from the devaluation of the baht The profits were estimated to be in the billions of dollars IV Conclusion Through the story of the speculative attack on Thailand, financial and banking analyzes and reports, we have a clearer view of developments, market psychology, and the health of businesses and corporations group or an entire country from there to evaluate and seize the opportunity to make an investment deal V Reference Kinh tế 2006 - 2007 Việt Nam Thế giới, Thời báo Kinh tế Việt Nam, 2007 Ngân hàng Thái Lan Kawai, Masahiro and Kentaro Watsubo 1998, The Thai Einancial System and the Baht Crisis: Process,Causes and Íessons, Mimeo, Insttute of Soclal Science,UUniversity of Tokyo Alb, P, Amar Bhattachharya, Stijn Claessens, Swai Gosh, and Leonardo 'Hernandez, The Role of Macro-cco- nomies án EFinancal Sectori Linkages in East Aisas Financial | Crisis Mimeo, Word Bank,| Washington, D.C ] Bộ Tài chính, Hội thảo Hệ thống Chính sách Thuế Việt Nam, 20/4/2007 Báo Vietuamnet, Chính sách \ tài khóa sách tiền tệ, | 20/11/2005 16 Vietnamnet, Đối phó với lạm phát Tất tổ chức tín dụng phải tăng tỷ lệ dự trữ bất buộc, 21/04/20 Analyze the crisis in Thailand based on the theory of Impossible Trinity Nguyen Thi Thuy Chinh - Bui Hong Hanh - Nguyen Thi Loan 17