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Contracting foreign exchange rate risks: a behavioral law and economics perspective on KIKO forward contracts

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  • Haksoo Ko
  • William Moon

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 fluctuation stayed within a narrow band. In 2008, however, the Korean currency depreciated considerably following the global financial 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 financial contracting. While the scope of this paper is limited to the KIKO contracts, the principles used to examine this case can be broadly applied. Copyright Springer Science+Business Media, LLC 2012

Suggested Citation

  • Haksoo Ko & William Moon, 2012. "Contracting foreign exchange rate risks: a behavioral law and economics perspective on KIKO forward contracts," European Journal of Law and Economics, Springer, vol. 34(2), pages 391-412, October.
    • Handle: RePEc:kap:ejlwec:v:34:y:2012:i:2:p:391-412
    DOI: 10.1007/s10657-010-9204-9
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    References listed on IDEAS

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    Cited by:

    1. Kim, Sungjae F. & Chance, Don M., 2018. "An empirical analysis of corporate currency risk management policies and practices," Pacific-Basin Finance Journal, Elsevier, vol. 47(C), pages 109-128.

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    More about this item

    Keywords

    Behavioral law and economics; Foreign exchange forward contracts; Knock-in knock-out contracts; K00; K22;
    All these keywords.

    JEL classification:

    • K00 - Law and Economics - - General - - - General (including Data Sources and Description)
    • K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law

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