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Eur J Law Econ DOI 10.

1007/s10657-010-9204-9

Contracting foreign exchange rate risks: a behavioral law and economics perspective on KIKO forward contracts
Haksoo Ko William J. Moon

Springer Science+Business Media, LLC 2010

Abstract Between 2006 and 2007, hundreds of export-oriented South Korean companies entered into what are called KIKO (knock-in, knock-out) target forward contracts to hedge against the threat of an appreciating Korean currency, the Won. Buyers of these contracts were assured a pre-determined foreign exchange rate as long as the range of exchange rate uctuation stayed within a narrow band. In 2008, however, the Korean currency depreciated considerably following the global nancial crisis, forcing buyers of the KIKO contracts to incur enormous losses. Why were there both supply and demand for these contracts, and why did they become suddenly popular? This article employs a behavioral law and economics perspective to explain what transpired in the minds of the parties to the contracts. Psychological biases and cognitive limitations were perhaps at play, including herd behavior, investor myopia, information cascades, and optimism bias. Recognizing that these psychological factors could induce sub-optimal decisions of the contracting parties, we argue that de-biasing should be considered an important policy goal in nancial contracting. While the scope of this paper is limited to the KIKO contracts, the principles used to examine this case can be broadly applied. Keywords Behavioral law and economics Foreign exchange forward contracts Knock-in knock-out contracts JEL Classication K00 K22

H. Ko (&) Seoul National University School of Law, Seoul, Korea e-mail: hsk@snu.ac.kr W. J. Moon Yale Law School, New Haven, CT, USA

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1 Introduction Between the years of 2006 and 2007, scores of export-oriented Korean companies entered into what are known as KIKO (knock-in, knock-out) target forward contracts to hedge against the threat of appreciating Korean currency, the Won.1 The contracts gave, among others, exporting companies the right to sell US Dollars for Won at a pre-arranged strike price so long as the exchange rate did not uctuate drastically. One major caveat was that the contracts were structured in a way that, in the event of the Wons signicant depreciation beyond a set threshold, the exporting companies which bought these contracts would have to pay a large sum to their contracting counterparties. Unfortunately for these exporting companies, the Korean Won depreciated signicantly against the Dollar in 2008 following the global nancial meltdown,2 exposing these KIKO contract buyers to big nancial losses, to such an extent that some companies were forced to le for bankruptcy.3 It is reported that, by 2008, over 500 companies had entered into the KIKO currency option contracts, vast majority of them being small and mid-sized companies.4 The exporting companies,5 facing signicant nancial losses, brought complaints to regulators such as the Financial Supervisory Service and the Korea Fair Trade Commission and started a series of lawsuits against banks in an effort to invalidate their KIKO contracts, based on grounds that include fraud, mistake, and changed circumstances. In several of these cases, the courts granted preliminary injunctions to these exporting companies and, in some other cases, the courts have found the banks partially liable, which has sparred vast controversy in Korea and beyond. This article is an attempt to understand the dynamics of the KIKO currency option contracts from a law and economics perspective. Our approach is premised on the recognition that applying the rational choice model to the reality of Korean export companies would not fully explain what seems to be suboptimal decisions on the part of these export companies when they entered into the contracts at issue. We explore the behavioral law and economics literature to understand the failure of the exporting companies to foresee the potentially devastating effects of the KIKO contracts. Specically, we examine whether the companies were imperfectlyrational, being unduly myopic and optimistic in their decisions to enter into the KIKO contracts. Also, due to limited organizational resources to effectively grasp the complex nature of these contracts, companies were perhaps inuenced by a herd

These contracts are commonly called KIKO contracts, so in this article, we use the term the KIKO contracts or the KIKO currency option contracts to refer to these contracts. There are variations of these contracts and such variations have different structures and different names but, for the purposes of this article, the variations and resulting differences are not signicant. The Won, which closed at 935 Won per Dollar in 2007, for example, closed as low as 1525 Won per Dollar in late November of 2008, Kim (2008). Lee (2009). As of June 2008, small and mid-sized exporting companies accounted for 480 out of 519 companies that entered into KIKO contracts. Lee and Kim (2009, p. 48). For the purpose of this paper, exporting companies refers to companies that sell goods abroad for their primary source of revenue.

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mentality within the exporting industries to jump on the bandwagon that drove them into the contracts without full apprehension of the possible future ramications. By analyzing these contracts and their formation process, we strive to provide a novel understanding of the realities behind the KIKO contracts. It is shown that the problems of systematic imperfection stem both from human nature and from organizational resource constraints. Principal-agent problems also played a role in forming the contracting parties incentive structures. In analyzing the circumstances surrounding KIKO, our piece also challenges the extant literature that has neglected to consider the organizational resource limitations and heuristic biases that plague many small and mid-sized organizations. The remainder of the article is organized as follows. In Sect. 2, we provide background information on currency exchange rate option contracts and explain the contractual structure of the KIKO contracts. In Sect. 3, we provide an overview of the legal issues surrounding the disputes concerning the validity of KIKO contracts. In Sect. 4, we examine relevant issues from law and economics perspectives, rst employing a rational choice framework and then a behavioral law and economics framework. We conclude after drawing normative policy implications.

2 Background on the KIKO contract Many currencies around the world, including the Korean Won, are traded under exible exchange rate regimes, where uctuations of certain economic variables sometimes cause a large change in the relative value of a currency. An important aspect of the exible exchange rate regimes to international trade is the inherent risk borne by exporting companies who pay for their materials using domestic currency but earn revenues in foreign currency, the latter of which is subject to exchange rate volatility.6 These companies would want to secure some sort of insurance against the risk of foreign exchange rate uctuation, which would allow them to minimize uncertainties in their revenue stream. Hedging is a way to minimize the uncertainty that inherently and inevitably exists in the currency exchange market. It could conceptually include put options and call options. Call options give option purchasers the right to buy currency at a specic rate (i.e., strike price) sometime in the future (e.g., maturity date), while put options give a right to buyers to sell currency at a specic rate sometime in the future. For exporting companies, the put option would allow them to fully protect themselves against volatile exchange rate uctuations by allowing them to sell currency A (for instance, Dollars) for currency B (for instance, Won) at the strike price, even if the market exchange rate is below the strike price. And since option is a right but not an obligation, if the market rate is above the strike price, companies can then sell currency A at the prevailing market price instead of exercising their right based on the option.
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The Won-Dollar exchange rate is the most important exchange rate for many Korean exporting companies. The KIKO option contracts were mostly regarding the Won-Dollar exchange rate, although there were contracts involving other currencies such as Japanese Yen. In this article, for expositional convenience, the exchange rate is used to mean the foreign exchange rate between Dollar and Won.

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The KIKO currency option contracts are unique in that, in addition to granting a put option to the contract buyer, they also give a call option to the contract-selling bank. This feature of the call option is the knock-in feature, which requires buyers to sell Dollars at the below-market strike price if the Dollar appreciates signicantly beyond a certain threshold level. In structuring the KIKO contract, the knock-in feature was added mainly because doing so allowed the reduction in the put option premium.7 And, to further reduce the upfront hedging costs, companies also entered into the KIKO contracts with the knock-out feature. With the knock-out feature, the market exchange rate would apply to foreign exchange dealings in the event that the foreign exchange rate is lowered below a certain threshold level. That is, if the Dollars value depreciates below the set threshold level, no option can be exercised by either party; if the parties wish to exchange Won for Dollars, or vice versa, they are simply required to do so at the prevailing market rate. Thus, the buyers of these option contracts were given de facto insurance against possibilities of modest changes of the exchange rate, whereas they were exposed to greater risks against possibilities of signicant depreciation of the Won. For obvious reasons, the contract with this structure would be particularly attractive for exporting companies in cases where it is highly likely that currency would uctuate within a relatively narrow range. On the other hand, if there are meaningful possibilities that currency could uctuate beyond a pre-specied narrow range, exporting companies would have to incur a great deal of losses under the contractual scheme of the KIKO contracts. Although the KIKO contracts were commonly characterized as and referred to as hedging contracts, in terms of their structure and effect, they were more of a combination of hedging and speculation contracts. To illustrate a specic example of a KIKO contract,8 assume that a company entered into a KIKO contract worth $100,000, with the following features: (1) strike price of 1,000 Won/Dollar; (2) knock-out rate of 900 Won/Dollar; (3) knock-in rate of 1,100 Won/Dollar; and (4)1:2 leverage.9 If the currency exchange rate does not go above 1,100 Won/Dollar or below 900 Won/Dollar during the contract period,10 and if the exchange rate at maturity is, for instance, 960 Won/Dollar (or, more generally, below 1,000 Won/Dollar), then the company will exercise its option
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The KIKO currency option contract is typically a hybrid contract including both the exporting companies put option and the banks call option. This structure allowed the parties to structure the contract in a way that both could realize identical overall expected prots, which in turn allowed lowering premium fees for the companies. Perhaps reecting this structure, the KIKO contract was described and marketed as a zero-cost product. This example resembles a typical window of a KIKO target forward contract. With a window barrier, the calculation as to whether knock-in or knock-out would be activated is done relatively frequently, e.g., on a monthly basis, while the contracts overall term may be 1 year. See Lee and Kim (2009, pp. 1920). With the 1:2 leverage structure, buyers of the KIKO contract would be responsible for coming up with twice the amount of currency they have signed for, which leads to the amplication of their losses in the event that incurring losses are inevitable for the buyers. The KIKO contract with 1:2 leverage was the most common type among various possible leverage alternatives, although there were some contracts with 1:1 leverage or 1:3 leverage structures.

A typical contract period is 1 year, and oftentimes the calculation to determine whether to activate the knock-in or knock-out features is done on a monthly maturity basis. For simplicity, the illustration in the text is given based on the assumption that the contract period has only one maturity. The illustration also ignores fees charged by the banks.

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Eur J Law Econ Table 1 KIKO option illustration Scenarios The exchange rate falls below 900 Won/Dollar during the contract period (Knock-out) The exchange rate does not reach 1,100 Won/ Dollar (upper threshold) or 900 Won/Dollar (lower threshold) during the contract period Consequences The contract loses its effectiveness If the exchange rate at maturity is lower than 1,000 Won/Dollar, then the company gains since it can sell Dollars at the strike price If the exchange rate at maturity is higher than 1,000 Won/Dollar, since the market price is higher than the strike price, the company would not exercise their right The exchange rate reaches 1,100Won/Dollar during the contract period (Knock-in) If the exchange rate at maturity is lower than 1,000 Won/Dollar, the bank would not exercise its right If the exchange rate at maturity is higher than 1,000 Won/Dollar, the company suffers by having an obligation to sell twice the contracted amount at the strike price

by selling the Dollar at the above-market strike price of 1,000 Won/Dollar, for a gain of 4,000,000 Won. If the currency exchange rate does not go above 1,100 Won/ Dollar or below 900 Won/Dollar during the contract period and if the exchange rate at maturity is 1,050 Won/Dollar (or, more generally, above 1,000 Won/Dollar), then the company will simply sell Dollars at the market rate since the market rate is higher than the strike price. If the exchange rate falls below 900 Won/Dollar during the contractual period, the contract loses its effectiveness, leaving the company vulnerable to any exchange rate volatility. If the exchange rate rises above 1,100 Won/Dollar during the contractual period, the company would be obligated to sell Dollars at the request of the contracting bank. In such a case, due to the 1:2 leverage structure, the amount that the company would have to sell becomes $200,000; not $100,000. Thus, if the exchange rate is 1,050 Won/Dollar (or, more generally, above 1,000 Won/Dollar) at maturity, companies would have to sell $200,000 at the strike price of 1,000 Won/Dollar, losing an opportunity to gain based on the appreciated Dollar or incurring losses since they would have to purchase Dollars at the market rate only to sell them to the contracting bank at the strike price. On the other hand, if the exchange rate at maturity is 950 Won/Dollar (or, more generally, below 1,000 Won/ Dollar), then the strike price is above the market price and therefore the bank would not exercise its option. Table 1 summarizes the basic tenets of this KIKO contract. Between 2006 and 2007, when KIKO contracts were beginning to be widely available, research institutions around the world predicted slow but steady decline of the Dollar against the Won.11 In fact, while the exchange rate had hovered around
11 For instance, Morgan Stanley, in December of 2007, predicted that the currency would hover around 900930 Won/Dollar throughout 2008; Citi Group estimated the gures to be between 880 and 900 Won/ Dollar during 2008; and Korea Development Bank predicted that the average exchange rate for 2008 would be 905 Won/Dollar. Forecasts of these institutions announced toward the end of 2006 about the foreign exchange rates in 2007 were generally similar, with slightly higher rates. See Lee and Kim (2009, p. 42).

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1,200 Won/Dollar in 2003, it steadily declined to approximately 1,000 Won/Dollar in early 2006 and many expected that the trend would continue. Moreover, the forward exchange rate indicated that the market was predicting a continued decline of the Dollar.12 While exchange rate uctuation in general was a cause for concern for exporting companies, the Wons appreciation was a more serious concern for these companies. An appreciated Won would mean losing price competitiveness in the foreign market and lower prot margins for these companies. Between 2006 and 2007, while the trend suggested a slow and continued decline of the Dollar, the range of uctuation of the foreign exchange rate did not exceed 60 Won. With a stable exchange rate, KIKO contracts were particularly attractive to exporting companies. The exchange rate stability, however, did not last long. In 2008, the Korean Won depreciated signicantly following the global nancial crisis, exposing the companies to extreme prot-losses. In response, these companies have brought lawsuits challenging the validity of the KIKO contracts. The courts have yet to render nal decisions for many of these cases, but in some of the cases, the court has granted preliminary injunctions in favor of the export companies. In one widely reported case, the court made its decision to grant a preliminary injunction reasoning that the surrounding circumstances changed so drastically to warrant the courts intervention in the form of granting a preliminary injunction.13 The court sided with the plaintiff company that the parties could not anticipate the possibility of unprecedented depreciation of the Korean Won.14

3 Legal issues surrounding the disputes over the KIKO contracts Many lawsuits seeking preliminary injunctions were led in late 2008, and the courts began rendering judgments in late 2008 and early 2009. Certain legal issues can commonly be observed in many of these cases, including the following. 3.1 Unfair form contract One argument made against banks is that the KIKO contract violates a Korean statute regulating standard form contracts.15 That is, it is argued that the KIKO
12 For instance, the forward exchange rate was lower than the market exchange rate in the spot market. Specically, as of December 3, 2007, while the exchange rate in the spot market was 938.6 Won/Dollar, the forward exchange rate was 934.2 Won/Dollar with 1 month maturity, 925.6 Won/Dollar with 3 month maturity, 922.6 Won/Dollar with 6 month maturity, and 921.6 Won/Dollar with 12 month maturity. This clearly indicates that the market was expecting the continued decline of the Dollar. Korea Federation of Banks (2009, p. 6). 13 Seoul Central District Court, 2008kahap3816 Preliminary Injunction Decision, December 30, 2008 (hereinafter the Monami case). 14 After the courts decision was rendered for this case, the media paid widespread attention to cases related to the KIKO contracts. The rst courts decision on KIKO on the merit for a regular case (not a preliminary injunction case) was rendered on February 8, 2010. The court sided with the banks. Seoul Central District Court, 2008gahap108359 Decision & 2009gahap28276 Decision. 15 yakkwaneui kyujee kwanhan bopryul [Act Concerning Regulation of Standardized Contracts], Law No. 8632.

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contract is inherently a form contract with standard boiler-plate provisions and that the KIKO contract is not valid since it contains terms that are fundamentally unfair and disadvantageous to the companies, violating the law which proscribes unfair provisions in a form contract. A fundamental issue in this context is whether the KIKO contract qualies as a standard form contract. To determine this, important considerations that would have to be made include whether it should still be considered a form contract when certain important terms such as the contract period, knock-in rate, knock-out rate and leverage were separately determined on a caseby-case basis, while many other provisions remain the same. This issue became practically moot when Koreas Fair Trade Commission determined that it would not be possible to declare that the KIKO contracts are overall inherently unfair to the companies since the end result of an individual contract would be different depending on exchange rate uctuations.16 3.2 Fraud; unconscionability; mistake The allegation in this context would be that banks deceived export companies and fraudulently induced them to sign the KIKO contracts; that the terms of the contracts were inherently unfair and disadvantageous to the contract buyers; and/or that the parties made serious mistakes in entering into the contracts. Complaining companies argue that, due to these reasons, the KIKO contracts should become void or voidable. The decision as to whether any of these arguments deserve merit would in some crucial aspects hinge on factual circumstances of an individual case. As a general matter, however, it would not be easy for many export companies, which regularly enter into business transactions with domestic and international parties and which are constantly exposed to foreign exchange risks, to argue that they are the victims of a fraud, of an unconscionable contract, or of a serious legal mistake in the foreign exchange market. 3.3 Duty to explain; duty regarding suitability and appropriateness Regarding the role of banks in the process leading up to the execution of the KIKO contract, two types of duciary duties are involved. The rst is the duty regarding suitability and appropriateness, and the other is the duty to explain. First, banks have a duty to acquire and maintain a certain level of understanding about their customers, for instance, about their nancial health, the type of their industry, and their ability to bear risks. Banks should also refrain from advising products that may not t with their customers best interest. Second, banks have a duty to fully explicate the important doctrines and nancial risks involved with their products. Determination as to whether any of these duties were violated would also be factspecic. That is, factual details about the parties understanding and communication prior to the execution of the KIKO contract would have to be examined carefully to determine whether the banks performed their duties.
16 Korea Fair Trade Commission Press Release, kiko, bulgongjeongyakkwan anida [KIKO is not unfair form contract] (July 25, 2008).

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3.4 Changed circumstances If the circumstances surrounding contract execution undergo drastic and fundamental changes, then the performance of contract obligations could possibly be excused. Relying on this principle, export companies claim that the KIKO contract should be deemed unenforceable since the degree of uctuation of the exchange rate that the parties anticipated and took into account when estimating the values of the underlying options was signicantly different from the actual uctuation of the exchange rate. A Korean court indeed acknowledged the possibility of invalidating a contract due to the change of circumstances.17 However, the circumstances that the court would consider in this context should be objective circumstances in nature and not subjective or personal. Then, even if it can be agreed that there was a signicant change of circumstances regarding the exchange rate, the controlling legal issue would be whether the relevant circumstances should be considered objective circumstances, or subjective and personal circumstances.

4 Economic analysis of the KIKO contracts Analyzing the validity of various arguments made by the parties would obviously be crucial for the courts and for the eventual resolution of the disputes. It is, however, not the main focus of this article. Instead, we focus on the process through which the parties decisions were made. Thus, in this section, attempts are made to analyze the parties motivations for entering into the KIKO contracts. In doing so, the analysis in this section tries to answer the following question: What explains the unique contractual design features, and the failure of the exporting companies to apprehend the magnitude of risks inherent in these contracts? An explanation based on the rational choice model is rst supplied. While much can be explained under the rational choice framework, there remain some unsatisfactory aspects. Thus, a behavioral law and economics perspective is introduced for complementary analyses. Below, we start from the rational choice model and then move to behavioral theories. 4.1 Rational choice model An underlying assumption of the rational choice model is that individuals possess unlimited resource capacity such as time, attention, and computational abilities to ascertain the subjective value of each alternative option to maximize their own utility.18 Because many of the companies that entered into the KIKO contracts were mid-sized or small-sized, many of them were constrained in terms of liquidity and resources. Also, between 2006 and 2007, the Won appreciated to an eight-year high, which posed an additional problem for these export companies since an appreciated Won meant losing competitive edge for their goods sold abroad. The catch of the
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Supreme Court, 2004da31302 Decision, March 29, 2007. On the rational choice theory, see, e.g., Posner (1998).

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Eur J Law Econ Fig. 1 Historical exchange rate (Won/Dollar). Source: Federal Reserve Bank of St. Louis, Exchange Rates (2009), available at http://research.stlouisfed.org/ fred2/categories/15

KIKO contract, of course, was that the loss derived from a large uctuation in exchange rates would have an amplied impact, if the knock-in feature is in effect and if the contract has the usual 1:2 leverage structure. Considering the forecasts of many prominent research institutions predicting the Wons gradual appreciation, it was natural for many market participants, including exporting companies, to be tempted to expect the same. On the other hand, given the historical volatility of the Korean currency, there were reasons to be cautious and to expect that the currency exchange rate may not remain stable for a long period of time. In fact, as Fig. 1 illustrates, the exchange rate of the Korean Won has uctuated widely over the past decade. During the period between the late 1990s and mid-2000, particularly volatile periods include the period associated with the Asian nancial crisis in the late 1990s. Thus, in gauging Wons volatility, a very different conclusion could be reached depending on whether the impact of the Asian nancial crisis is considered a statistic outlier. That is, once the period of major shock owing to the Asian nancial crisis is excluded in considering foreign exchange rate volatility, one could argue that the Wons exchange rate stayed within a relatively narrow range during a 10-year period until 2007. If anything, the Won was steadily but slowing appreciating during the 5-year period between 2002 and 2007. Under these circumstances, were decisions by Korean exporting companies to buy the KIKO contracts rational? Prior to answering this question, one needs to consider what the rational way would be in making predictions about the foreign exchange rate.19 A standard method of foreign exchange rate forecast is what is called the fundamental approach, which uses fundamental economic variables, such as national income, consumption, trade balance, money supply, ination rate, and interest rates, in order to generate an equilibrium exchange rate.20 Since variables
19 For the literature on the economics of exchange rate, see Taylor (1995), Isard (1995), Sarno and Taylor (2003). 20 Although using economic fundamentals to forecast exchange rates would be conceptually sound, there is evidence that, at least for a short to medium-term period, economic fundamentals often do not have much predictive power. See, for one of the rst attempts to report and analyze this phenomenon, Meese and Rogoff (1983). There is also a very different approach, which can be called the technical approach. Under the technical approach, various charts and statistical techniques are used to predict exchange rates

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like the future ination rate and interest rate are impossible to know ahead of time, the model makes assumptions about future values of these economic variables, which in many ways accounts for the inability of forecasts to often correctly predict future exchange rates. Perhaps due to this inherent limitation, even some of the observers that adhere to the fundamental approach to forecasting exchange rates concede that the approach may not be applicable to short-run uctuations.21 It is not clear if Korean exporting companies employed or were even aware of the fundamental approach, or whether they made decisions as indicated by the rational choice model. Nonetheless, some aspects of the decisions made by these companies may be explained within the framework of the rational choice model. First, while KIKO contracts started to be offered in late 2005 in South Korea, it was not instantly popular. Instead it all of a sudden became most popular in 2007, when the currency had remained stable for a considerable period of time and the range of uctuations had been minimal, which is arguably when the KIKO contracts became most attractive.22 Currency uctuation is a form of risk and, by entering into the KIKO contracts, rational actors were arguably reacting to their assessment of lowered risk by buying an option product which had better conditions for them, i.e., a product with less hedging and a better price. Given the forecasts of many research institutions predicting the Wons stabilization or slight appreciation, it seems reasonable for these companies not to enter into the standard hedging contracts and instead to opt for the KIKO contract since the standard contract would require payment of a higher premium. Moreover, since forecasts by credible actors typically have a signicant impact on consumer condence and on the overall market, it was reasonable for these export companies to make decisions based on the predictions of major research institutions. While the rational choice model explains some of the observed phenomenon, it does not provide a complete account. For instance, the open possibility of losing an enormous amount in the event of the Wons signicant depreciation that would threaten the very existence for some of the companies, along with the wide prevalence of the KIKO contracts amongst certain group of small and mid-sized exporting companies, cannot be fully explained within the rational choice framework. 4.2 Behavioral law and economics model To ll the explanatory gap, we apply the behavioral law and economics framework to the KIKO currency option contracts. This framework will complement the rational choice model and explain the design structure and the popularity of these
Footnote 20 continued based on past exchange market developments. Academic debates have been made and will continue to be made to reconcile the differences between these different approaches and to enhance predictability of exchange rate uctuations.
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de Grawe and Grimaldi (2006, p. 9). Some empirical ndings show that the exchange rate may move widely even when there is very little shift in the fundamental values.

22 The KIKO contract was especially popular during a few months in the second half of 2007 and in January 2008. Lee and Kim (2009, p. 48).

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contracts. One common account of these contracts argue that the banks were deceitful and pushed risky KIKO contracts onto exporting companies. On the other hand, another common account focuses on the exporting companies which knew or should have known the associated risks entering into the KIKO contracts, but which made reckless and irresponsible decisions nonetheless. Both accounts capture some of what was going on, but neither account is complete either. In many cases companies did not appear to be reckless. Banks were not entirely at fault either. They were simply responding to a market demand for nancing that was driven by the exporting companies imperfect rationality. Below we examine both the supply side (i.e., banks) and the demand side (i.e., exporting companies) from a behavioral law and economics perspective. 4.2.1 Banks principal-agent problem What appears to have taken place with at least some of the banks is that they did not go out of their ways to warn the companies about the risks involved with the KIKO contracts. The CEO of an affected company asserted that banks never, never notied us of these KIKO options high risks they said they were 99% sure the Won would continue to rise.23 Some court rulings appear to support this contention. That is, although provisions on the knock-in obligation were emphasized in the contract, the bank might have advised the company that, in all likely circumstances, the Won would slowly appreciate, eventually making the company believe that the KIKO contracts were a sure bet.24 In some cases, banks also explained the structure of the contract only using scenarios where the exchange rate uctuated within a narrow range of 6070 Won/Dollar.25 Banks deny the claim that they essentially proted off of the contracts without incurring much risk themselves.26 Because the banks often re-sold the KIKO products, the amount of their gain was not directly related to the amount that the buyers of the contracts lose. Indeed many banks sold the contracts to foreign banks and hedge funds in order to hedge their own risks.27 The re-selling of the KIKO contracts might have created a serious principal-agent problem, similar to the problem caused by the securitization process in the meltdown of the US mortgage market.28 In the KIKO contracts, domestic banks that sold the contracts essentially
23 Claim of Kim Sang In, chief executive ofcer of a Korean construction-equipment maker. See Lim (2008). 24 25 26

Monami case, p. 23. Ibid.

Of course, if the risk of default and the risk of the contract validity being challenged are also considered, the banks should be considered to have assumed signicant risks.
27 For banks contracting schemes to manage their own risk positions, see Lee and Kim (2009, pp. 4548). 28 Some observers claim that the main culprit behind the US mortgage crisis was securitization, which created a host of agency problems. The compensation for these agents-intermediaries, who were assigned the role of originating loans, pooling mortgage-backed securities, and assessing the risk associated with the different securities, was not designed to align their interests with those of the principals-investors. Their fees were, for instance, based on the quantity, not quality, of processed loans. As a result, the

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Eur J Law Econ Fig. 2 The KIKO agency problem

served as intermediate salespeople between the exporting companies and foreign banks/hedge funds. It is indeed the latter group which mostly cashed in on the decline of the Korean currency in 2008. Main participants in the KIKO contracts and their contractual relationships are illustrated in Fig. 2. Since banks served merely as intermediaries in this relationship, they did not have to absorb meaningful risks associated with the structure of the contract. Since the banks fees were based on quantity and not quality of the products sold, their incentive was inherently to push through volume.29 However, even if it may be true that banks had a strong incentive to sell the KIKO contracts, it does not, by itself, mean that they are the main culprit. This requires examination of the demand side. 4.2.2 Investor myopia The other side of the story focuses on the KIKO contracts as a market response to the imperfect rationality of export companies. Myopic companies would unduly focus on short-term dimensions of the contracts and pay insufcient attention to long-term dimensions. If myopic exporting companies are mainly concerned about the short-term results and discount the long-term ramications heavily, then banks would respond by offering deferred-cost contracts with low short-term prices and high long-term prices.30 The KIKO contracts offered low upfront costs, in the form of low option premium, but higher future costs by limiting the range of uctuations of the exchange rate that the companies would be insured against and by even exposing the companies to the possibility of amplied losses. Imperfectly rational myopic buyers would be unable to effectively aggregate multiple price and nonprice dimensions and discern from them the true total cost of the contract.31 A vast majority of the Korean exporting companies that signed the KIKO contracts were small to mid-sized companies which most likely lacked sufcient
Footnote 28 continued agents-intermediaries had an incentive to increase the volume, even when it created low-quality, high-risk loans. See Bar-Gill (2009).
29 Seoul Central District Court, 2009kahap393 Preliminary Injunction Decision, April 24, 2009, p. 9 and p. 19; Seoul Central District Court, 2009kahap207 Preliminary Injunction Decision, April 24, 2009, pp. 78. 30 A similar market situation was observed prior to the US subprime mortgage meltdown, where banks offered complex mortgages that had small down-payment and small short-term monthly payment, but higher monthly payments in the future. See Bar-Gill (2009, p. 31). 31

Ibid.

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Eur J Law Econ Fig. 3 Exchange rates 20022007 (Won/Dollar)

analytical capability to assess the future volatility in the foreign exchange market and to make an adequate arrangement to hedge against foreign exchange risks. The KIKO contracts were structured in a way that limited gains that can be made by the buyers, while the amount of potential losses was typically larger due to the leveraged structure. This is an interesting characteristic different from standard hedging contracts, which limit potential losses. It is hard to think that companies went for the more risky KIKO contracts unless they had virtually no reason to consider the possibility of the Wons signicant depreciation seriously.32 The choices made by exporting companies may be explained using a behavioral economics framework. First, availability heuristics would lead people to underestimate the likelihood of events with low-probability or low-salience because these threats simply do not make it onto peoples radar screens.33 That is, to exporting companies, the Wons relative stability during the several years prior to their signing of the KIKO contracts was a salient feature in the foreign exchange market, while the Wons volatile move in the previous decade somehow disappeared or was discounted heavily in their analytic minds. Furthermore, individuals tend to judge the likelihood of uncertain events by how available such instances are to the human minds, and this may depend on factors unrelated to the actual probability of the event.34 In this context, the information conveyed through Fig. 3 and the resulting perception of foreign exchange rate stability could be signicant. Figure 3 depicts the moves of the exchange rates during the ve-year period between 2002 and 2007, which shows a general trend of a stable yet gradually depreciating Dollar.35 Compared to Fig. 2, Fig. 3 gives a fairly different impression about the volatility of the Wons exchange rate. Figure 2 covers a longer period of 10 years and includes the period of the Asian nancial crisis and, while Fig. 3 shows a relative stability of the foreign exchange rate, Fig. 2 would suggest that the exchange rate could move with some degree of volatility. Investor myopia indicates that, between different levels of exchange rate volatility as represented by Figs. 2 and 3, Fig. 3 would more likely gure prominently when one makes decisions.
32 This is especially true considering that the pricing of an option is partly based on how much hedging the option offers. Since the KIKO contract offered less hedging, the premium would be naturally cheaper compared to the standard exchange rate hedging options. 33 34 35

Jolls et al. (2000, p. 13 and 38). Ibid., p. 47. This period does not include the period affected by the Asian nancial crisis.

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Moreover, if we consider the 2-year period between 2006 and 2007 only, the Wons stability is even more prominent. Thus, a myopic investor might have believed that, by 2007, the period of volatility in the foreign exchange rate virtually disappeared. Given the period of relative stabilization in the currency exchange market during previous several years in Korea, it is likely that availability heuristics compelled many of the export companies to neglect what happened during the Asian nancial crisis just a decade ago, and thus ignore the possibility of signicant appreciation of the US Dollar relative to the Korean Won in a matter of months. Research on availability heuristics shows that many decisions on the likelihood of uncertain events are inuenced by heuristic principles that simplify the complexity of a given situation. Although using heuristics is often useful and economical, it could lead to systematic and predictive errors in making estimation.36 Anchoring may have been at play as well. Anchoring effects refer to the tendency of individuals to rely heavily on an anchor in making decisions. That is, individuals may start from an anchor and may not fully appreciate changes in the surrounding environment; may be highly selective in the way that they gather and use information; may be overly inuenced by the initial starting point or the anchor; and thus may fail to adjust their judgment adequately when situations change. If individuals do not adjust sufciently from the anchor point when external circumstances change, biases could be introduced.37 In the context of the KIKO contracts, the relatively stable exchange rate experienced by the exporting rms may have served as the anchor point for exporting companies and they may have been unable to fully consider all available information from the previous decade in making their judgment to enter into the contracts. This idea is worth elaborating upon. It is an individuals tendency to concentrate on what is fresh in his or her mind that leads to myopic behavior and such a tendency leads to the possibility of disproportionately discounting future eventualities. When it comes to predicting exchange rates, individuals have limited ability to process and analyze available information, and thus may have no choice but to select simple forecasting rules.38 One type of strategy that can be employed is adopting certain rules and checking the protability of such rules ex post, and either sticking to the rules or switching to more protable rules.39 Memory plays an important role in this regard. In this trial-and-error strategy, individuals often weigh the past prots by giving increasingly smaller weight to periods further in the past.40
36 In one study, subjects were asked to predict the percentage of African countries in the United Nations. The subjects were given a number between 0 and 100 randomly determined by the wheel of fortune, were asked rst if the number was too high or too low, and were asked to estimate the value by adjusting that number. Median estimate for groups that were given by the group that received 10 from the wheel was 25, while median estimate for the group that received 65 from the wheel was 45, although the initial number had nothing to do with the actuality of the question at hand. Tversky and Kahneman (1974). 37 38 39

de Grawe and Grimaldi (2006, p. 9). Ibid. pp. 1319.

Ibid. pp. 1011. In a similar vein, Andrew Lo proposes what is called the Adaptive Market Hypothesis, which reects an attempt to reconcile the Efcient Market Hypothesis with the results of behavioral nance. Lo (2005).
40

de Grawe and Grimaldi (2006, p. 10).

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In fact, according to the literature on hyperbolic discounting, people may prefer sooner payoffs to later payoffs, even when it means sacricing the size of the total payoff.41 In the case of Korean exporting companies, a plausible explanation would be that their trial-and-error strategy gradually placed less and less value on the standard hedging contracts since these contracts worked well and were valuable under the circumstances of a highly-volatile currency but not when the currency stays stable. The increasingly stable exchange rate during several years before 2007 could have compelled the companies to place less weight on hedging itself, and instead place more value on minimizing the associated fees and costs. 4.2.3 Optimistic overcondence Closely related to myopic behavior is optimism that is prevalent in many organizational decision-making processes. Generally, optimistic bias includes behaviors that over-estimate the likelihood of positive events, and under-estimates the likelihood of negative events.42 In the context of the KIKO contracts, optimistic bias is a situation under which the buyers expect that the future volatility of the foreign exchange rate would be limited and that the possibility of the Wons signicant depreciation could practically be ignored. Optimistic bias can be reinforced once investors experience a positive result from their previous investment.43 Periods where exchange rates stayed relatively stable thus serve as a positive experience that fueled optimism. It is reported that companies competing in highly competitive markets are especially prone to overcondence, since employees are exposed to extreme competitive pressures to survive in the labor market.44 Risk-preferring agents will be more extreme in their results compared to risk-averse agents, thus producing some lucky risk takers who will outperform risk-averse agents. This would lead to the promotion of risk-preferring agents to managerial positions.45 In this context, the KIKO contracts, compared to the standard exchange rate hedging contracts, could be interpreted as lowering the degree of hedge, increasing the risks, and thereby lowering the option premium fees. Within individual companies, entering into the KIKO contracts instead of standard hedge contracts might have been viewed as a means to boost prot margins, with negligible increase in the associated risks. If so, internal reward structures or corporate governance structures may have induced managers to place their selsh motives above the long-term interest of their respective companies.

41 See, for general discussions on issues related to time discounting and time preference, including hyperbolic discounting, Frederick et al. (2004). 42 43

Kahneman and Tversky (2003), p. 730; Jolls (1998).

Dimson et al., using the US securities market, illustrate how positive memories of investors often inuence them to be irrationally optimistic. Dimson et al. (2004, pp. 1516).
44 45

Langevoort (2004), p. 93.

Heath and Jourden point out that optimism bias is more pronounced in small groups. Heath and Jourden (1997, p. 103).

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4.2.4 Investor herd behavior Human beings have an inherent tendency to follow what others do, and such a tendency may have played an important role in making the KIKO contracts suddenly popular. The role of information cascades, or the situation where many people end up making the same decision because of beliefs or actions of a few early movers, is worth noting here. When information cascades are at play, behavior of the rst small group of individuals can produce similar behavior from followers because of the positive signal transmitted by the cascades.46 Since signals are most effective when they come from credible sources, cascades coming from opinion leaders in the market would be particularly effective.47 In the case of the KIKO contracts, it should be remembered that the contracts began to be offered in 2005, but many companies jumped on the bandwagon in 2007. While the seeming stability of the foreign exchange rate should have played a role, it cannot fully account for why it became instantly popular in 2007, since exchange rates were relatively stable from mid-2002 on. Indeed, there is some economic logic to herd mentality. First, observing the behavior of other actors in the marketplace allows one to gather useful information at low or no cost. Herd mentality could be the strongest when limitations of time and natural intelligence prevent each individual from individually discovering all relevant information.48 This ts the rubric for many of the small and mid-sized exporting companies that signed the KIKO contracts, where the owners or their family members were oftentimes the managers. This, however, does not necessarily mean that herd behavior in the currency exchange market is optimal. If decision-makers are able to mindfully assess both their organizational capacities and the external environment, they are likely to join the bandwagon only if it is advantageous to their specic circumstances. It would also mean that organizations that do not have mindfulness will be more prone to less scanning, less context-relevant interpretations of the external herding behaviors, and less discriminating decisions in respect of bandwagons.49 Paying heed to other actors of the market would make one less attentive to his or her own information, which could yield welfare diminishing consequences.50 Indeed, for many Korean exporting companies, the fact that other exporting companies entered into the KIKO contract was freely available information that many companies could easily rely on to make decisions. Yet, it also allowed the companies to be less vigilant in scrutinizing the ramications that could arise out of entering into the KIKO contracts. The popularity of the contracts among many other companies may mean that potential contract buyers often had preconceived notions about the KIKO contracts even before the banks explained the product, which would have made the

46 47 48 49 50

Kuran and Sunstein (1999). Ibid.; Sunstein (2003, pp. 5474). Shiller (1995, p. 181). Fiol and OConnor (2003, pp. 6768). Banerjee (1992, p. 798).

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disclosure and explanation on their riskiness less relevant to its decision-makingprocess to begin with.51

5 Policy implications With the analysis from the behavioral law and economics perspective in mind, we briey consider normative policy implications. A main implication from the observations made above would be that policy measures in general should be geared toward ameliorating the impact of various cognitive limitations or biases that contracting parties may have. This of course would not necessarily justify the governments direct intervention in the market apparatus such as pricing or contract structure.52 This would also not necessarily mean that the courts should side with the companies for reasons such as changed circumstances. Instead, what can be done is to carefully examine the whole process through which parties have made decisions, eventually leading to the execution of the KIKO contracts, and to explore ways to de-bias the parties from the impact of the psychological factors discussed above. 5.1 Framing problem The KIKO contract has been called a hedging contract. As noted, however, considering its structure, it contains features of both a hedging contract and a speculation contract. Putting aside issues related to regulatory ramications, whether a contract is labeled as a hedging contract or as a speculation contract could have a signicant impact on the parties attitude and their decision-making processes.53 If labeled as a hedging contract, it would give its buyer the psychological comfort that would be analogous to the comfort available from buying an insurance scheme. On the other hand, if labeled as a speculation contract, it could induce the buyer to be additionally cautious since a speculation contract could be perceived to be similar to gambling. It is indeed well-known that, depending on how a given situation is framed and presented, individuals could make different choices.54 What is signicant in this context would be whether the situation after entering into the contract is perceived through a gain frame or a loss frame. If perceived as a gain, individuals would show a risk-seeking attitude, while showing a risk-averse attitude to what is perceived to be a
51 This in turn would mean that, to have a meaningful impact on the companies decision-making process, disclosure and explanation would take place at the earliest possible opportunity, if at all possible prior to the time when they form their expectations. Once these companies have preconceived expectations, banks role may need to include inducing them to break the existing expectations, which could sometimes be an exceedingly cumbersome procedure.

Examples of governments direct intervention would include directly setting limits on the amount of losses that an individual contract buyer can assume. Detailed discussion on the desirability or policy implications of this type of direct intervention is beyond the scope of this article.
53

52

For studies on the effects of framing on consumer behavior, see Levin and Gaeth (1988), pp. 374375, Bateman et al. (2001). This is a main lesson of the prospect theory. Tversky and Kahneman (1981).

54

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loss. To the extent that there is a policy interest in inducing exporting companies to be cautious and risk-averse in relation to their attitude toward risks related to foreign exchange rate uctuations, it could be desirable to label the KIKO contract as a speculation contract or at least as a combination of a hedging contract and a speculation contract. 5.2 Disclosure regulation As a general matter, legal rulings in KIKO cases need to be carefully attuned to promoting economic efciency in light of imperfectly rational actors in the market. On the one hand, it could be argued that siding with exporting companies would mean the courts invalidation of legally-binding contracts and would thus set an undesirable precedent that could threaten the very integrity of contracts as legally binding instruments.55 That is, one party that is not satised with the outcome of the contract could possibility use that as grounds to invalidate the contract, undermining the very function of contracts. Invalidating contracts to bailout exporting companies could induce companies to be even more risk-taking and introduce moral hazard. On the other hand, ruling in favor of exporting companies could compel, or at least incentivize, the banks to be more proactive in providing meaningful information to companies and in gauging these companies analytical and nancial capabilities. In this context, what needs to be emphasized is the signicance of adequate disclosure policy. In particular, to combat the organizational limitations of small and mid-sized companies, governments may need to step into regulate disclosure policy.56 Of course, the prescription of provide more information is striking in its sparseness, since it does not address the exact mechanism through which the information would be disbursed. In terms of providing information, what is important is the need to provide useful and practical information that focuses on minimizing the complexity and confusion that could stem from mandating more disclosure. This should be guided by the principle of de-biasing the parties from the impact of various biases and psychological limitations. First, banks would need to refrain from predicting or giving strong indications as to future exchange rate uctuations. If banks were to provide information on the projections prepared by third-party research institutions, they should do so only by supplementing such information with adequate warnings and cautions. These could include providing information regarding historical volatility of the exchange rates, the necessary shortcomings of foreign exchange rate projections, and ramications in case the projections turn out to be wrong. Such an approach would ameliorate the myopia and optimistic biases of the contract buyers. Second, a standard policy needs to be in placed, which would provide guidance concerning banks disclosure of various scenarios that can play out under the KIKO
55 Based on the Roman law doctrine of Pacta Sunt Servanda, these proponents believe that invalidating KIKO contracts would threaten the very integrity of contract law in Korea. 56 This prescription is consistent with court rulings in some of the KIKO cases. In these cases, the courts have ruled that the banks selling derivative nancial products should assume a high standard of duciary duty to the customer, giving them a mandate to provide information that would cater to the needs of the buyer. See, for instance, Seoul Central District Court, 2009kahap393 Preliminary Injunction Decision, April 24, 2009, pp. 1723.

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contract. For instance, a standard can be adopted under which banks are required, at a minimum, to show scenarios where the currency uctuates enough to activate the knock-in and knock-out parts of the contract.57 As noted, the knock-in and knockout features would only take effect if the currency uctuates beyond certain threshold levels. Neglecting to alert buyers about the possibility of exchange rate uctuations that would be enough to activate the knock-in or knock-out features and also failing to illustrate the effects of these features in some clear manner should be made to constitute a violation of disclosure requirements. While mandating this rule may still not fully inform the buyer of the risks involved with the contract, it could serve as a starting point to de-bias and to provide adequate warning. 5.3 Information-sharing scheme It would also be helpful to establish an information-sharing scheme among banks that will deter exporting companies from over-hedging and from becoming speculative beyond their nancial capacity. In the case of the KIKO contracts, problems were exacerbated from the way exporting companies entered into multiple contracts with different banks. Although individual banks placed a limit on the amount that each company can hedge entering into a KIKO contract, these banks did not know whether such a company had already entered (or, would likely enter) into a similar contract with another bank. When a company executes contracts with multiple banks, it is practically promising to sell Dollars more than what they would be capable of coming up with via their exporting business, in cases of leveraged option contracts. Thus, when the knock-in feature is in effect, companies could stack up losses beyond their control. An information sharing scheme, under which banks would share information as to whether a particular exporting company had entered into another similar contract, would help prevent exporting companies from entering into the KIKO contracts beyond their nancial capability. While information sharing had not been allowed in Korea due to privacy concerns, it has now become possible after revisions of relevant regulatory rules. A main limit of this new scheme, however, is that information sharing is allowed only on the basis of voluntary consent and participation by contracting companies. It remains to be seen whether the new scheme would help prevent the recurrence of similar problems in the future.58

57 In the Monami case, it appears that the knock-in and knock-out parts of the KIKO contract were not properly explained to the buyer and instead the bank only described what would happen if the exchange rate moved with the narrow range of 6070 Won. Monami case, p. 23. 58 There are several unresolved issues in this context. First, it is not clear if most companies would participate voluntarily. Second, there should be careful observation and analysis as to whether it would be enough to share information or whether more explicit and clear regulation would be needed, e.g., in the form of setting the upper limit in the contract amount that an individual company can hedge or speculate. Third, whether, if the privacy concern is indeed a serious and legitimate one, some other alternatives should be sought other than an information-sharing scheme. One alternative would be to reect the companies position in the representations and warranties part of the contract and, that way, to induce the companies to be forthcoming in some indirect manner. Detailed discussion of these issues is beyond the scope of this article.

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5.4 Efcient breach and contract modication In this section, we discuss economically sound legal principles that Korean courts may use to rule on the KIKO contracts that have already been entered into. After all, better disclosure policy could do little in resolving the current disputes between banks and exporting rms. We base much of this section on the principles of contract law and try to use contract principles as a prism through which insightful knowledge can be drawn for South Korean courts. One way to make good policy decision here is to reect upon the principles of contract modication. Since exporting companies are often long-term customers of banks, banks have an incentive to modify the terms of the contract thereby helping exporting companies out of a nancial disaster.59 At the same time, exporting companies will need to depend on the banks to secure loans and hedge against currency volatility in the future. Policy should capitalize on this incentive structure. Contract modication indeed occurred widely after the currency crisis in 2007, which suggests that signicant economic welfare enhancement can occur by adapting a sound contract modication regime. Here, the courts should perhaps pay attention to the possibility of opportunism that could arise as a result of their rulings by weighing the precedential effect of their rulings. From a legal standpoint, fact-nding in each case would obviously be extremely important, in particular with respect to the cases related to the KIKO contracts since the very premise of invalidating some of the contracts in some of the earlier cases was the banks failure to inform the companies of the risk involved with KIKO. In this regard, courts should not consider the sheer amount of nancial loss as a reason for invalidating the contracts.60 Considering the amount of nancial loss would only increase moral hazard. Some would argue that upholding modication of the contracts would undermine the integrity of contract law. This line of reasoning is related to the legal theory based on moral principles once advocated by, among others, Oliver Wendell Homes, Jr., who expressed that [t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it, and nothing else.61 While courts do need to be attuned to their role in deterring unnecessarily risky behavior by imperfectly rational rms, it seems unclear if allowing contract modication in these circumstances would reduce the integrity of contract law.

6 Conclusion The acceleration of international economic integration in the age of globalization has placed and will continue to place tremendous pressure on exporting industries to stay competitive. This is especially true for companies that trade under free-oating
59 Even in the most immediate sense, forcing the rms to go bankrupt could yield an inferior outcome compared to modication, since banks will face difculties recovering against bankrupt rms. 60 61

This appears to have been the case in some court proceedings, Seo (2009). Holmes (1897 p. 458).

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exchange rate regimes, since they earn their revenue in foreign currencies yet incur costs in domestic currency. The present essay made attempts to understand the systematic heuristic and organizational biases that are prevalent in many small to mid-sized companies by examining Korean exporting companies experience with the KIKO target forward contracts. Both the supply and demand sides of the KIKO contract market were to blame for the seemingly irrational behavior by the exporting companies in entering into these risky and peculiar currency hedging contracts. In the article, the agency problem that underlies the supply side of the equation was highlighted. Then the demand side was examined, where we show how companies may have been myopic, being unduly optimistic given the relatively stable currency during the period between 2002 and 2007. Also, they were perhaps swayed by herd mentality within their industries, given their organizational limitations that constrained them from fully examining the fairly complex contract structures and to make proper assessment regarding associated risks. Policy implications suggested in this article center on the theme of capitalizing on the incentive structure of the involved parties and of de-biasing the organizational heuristics responsible for the quasi-market failure. As a starting point to cure the problems, discussions were made as to how to frame and present the contract to market participants, i.e., whether to characterize the contract as a hedging contract or as a speculation contract. Then, it was argued that there is a need to adopt standard policies for banks in regards to the disclosure of information and that a new information-sharing scheme may be needed which would preempt companies from being too speculative. While the substantive scope of this article is limited to the KIKO exchange rate option contracts in Korea, the underlying principles could be more broadly applied to other types of currency option contracts in other settings.
Acknowledgments We thank Professor Richard R.W. Brooks of Yale Law School for sharing his invaluable insights. We also thank Professor Sangwon Suh and other seminar participants of the Institutions and National Competitiveness Conference, held in August 2009 in Seoul, Korea, for their helpful comments. Geary Choi and Joanne Koo provided excellent research assistance. David L. Simons provided superb editorial assistance. Kos research for this article was supported by the Law Research Institute at Seoul National University School of Law. This article was prepared while Moon was with the Center for International Economic & Business Law, Seoul National University.

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