Watch Out for Falling Chinese Derivatives: Banks Run for Cover as China Hedges Fuel Bets

As this story from Chinese markets shows, financial derivatives are often not what they seem.  If you plan to use derivatives to hedge risks, don’t forget the counterparty risks inherent in the derivatives themselves.

Highlighting once again the risks of doing business with state-owned Chinese companies, banks and the derivatives market took another hit on September 7 when the Chinese government encouraged state-owned airlines and shippers, including China Eastern Airlines Corp., Air China Ltd. and China Ocean Shipping (Group) Co., to legally challenge their fuel derivatives contracts with foreign banks.

The contracts were used by these companies to hedge against what they expected to be a steep rise in fuel prices.  When the prices fell — as they sometimes do in a market — the companies ended up losing millions.  The losses are premised on the assumption that the companies are legally bound by the derivative contracts. This assumption should have been questioned back in March 2009 when, according to China Daily, China’s State-owned Assets Supervision and Administration Commission (SASAC) “tightened the rules” governing State-owned enterprises’ (SOEs) use of derivatives under Chinese law.  Those who did not question then are certainly doing so now.

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