CITIC Pacific's Australian-dollar accumulators

A real exposure, hedged the wrong way

CITIC Pacific was a large, Hong Kong-listed conglomerate controlled by the Beijing state-owned CITIC Group. In 2006 it acquired mining rights to two billion tonnes of magnetite iron ore in the Pilbara region of Western Australia, the Sino Iron Project. Building the mine and its processing plant meant paying contractors and suppliers in Australian dollars and euros over several years, a genuine commercial exposure to a rising AUD and EUR, exactly the kind of risk forward contracts exist to manage.

CITIC did not buy plain forward contracts, one Australian dollar bought for one US dollar amount agreed today. Instead, from September 2007, its finance department began buying target redemption forward (TRF) contracts, sold in the market as "accumulators". These are asymmetric structures. If the AUD/USD spot rate stays above an agreed strike rate, CITIC buys its normal amount of Australian dollars cheaply, but the contract has a knock-out clause: once cumulative gains hit a cap, it terminates early. If the spot rate falls below the strike, there is no such limit. CITIC is obliged to buy a multiple of the normal amount, for example 2.5 or 3 times, at the now-unfavourable strike rate. The upside was capped. The downside was leveraged and open-ended.

Sixteen contracts in a month, as the crisis built

Between 8 July and 5 August 2008, in the space of about a month, CITIC bought sixteen new AUD TRF contracts. Twelve carried step-up features (rising strike rates), nine carried a leverage ratio of 2.5, and one carried a ratio of 3. At the same time, the global financial crisis was building. Capital was fleeing to the US dollar, and by early September 2008 the AUD/USD rate had already fallen from a peak near 0.98 to 0.88, a drop of more than 10% in weeks. A report to CITIC's Executive Committee on 4 September 2008 recorded that the amount of Australian dollars the company would be obliged to deliver under its outstanding contracts stood at AUD 3,510 million.

The Sunday Meeting and the circular five days later

CITIC's own account places the moment it grasped the scale of the problem at a meeting on Sunday 7 September 2008. Deputy finance director Leslie Chang emailed managing director Henry Fan just after midnight to request an urgent meeting; chairman Larry Yung and other senior executives gathered that morning. Five days later, on 12 September 2008, CITIC published a routine Stock Exchange circular about an unrelated transaction, stating the directors were not aware of any material adverse change in the group's financial position. That statement was made after the company already knew about its currency exposure, and it later became the centre of a regulatory case.

The profit warning and the 55% fall

The market itself was not told the scale of the problem until 20 October 2008, when CITIC issued a profit warning. It disclosed a realised loss of HK$626.6 million from terminating some of the TRF contracts, plus HK$128.6 million from other AUD hedging trades, and, far larger, a mark-to-market loss of HK$14.7 billion on the leveraged FX contracts still outstanding. CITIC shares fell from HK$14.52 to HK$6.52 the same day, a one-day fall of 55%, and kept falling the day after. CITIC Group, the Beijing parent holding 29% of the company, stepped in with a US$1.5 billion standby loan to shore up liquidity.

A hedge nearly six times the exposure it was meant to cover

The figure that explains what really went wrong is the size mismatch. By the time of the profit warning, CITIC's total AUD delivery obligation under the leveraged contracts was AUD 9.44 billion, against only AUD 1.6 billion of capital expenditure the Sino Iron Project actually still needed over the following two years, an over-hedge ratio of about 5.9 times. On the euro side the mismatch was smaller but still real: more than €160 million deliverable against €85 million of remaining need, roughly 1.9 times. CITIC had stopped hedging a real exposure. What it had built instead was, in effect, a large one-way currency bet, using instruments whose losses were multiplied exactly when the bet went wrong.

Resignations, tribunal, and a decade-long aftermath

The aftermath ran for years. In April 2009, days after Hong Kong's Commercial Crime Bureau searched CITIC's offices, chairman Larry Yung and managing director Henry Fan resigned. In September 2014 the Securities and Futures Commission (SFC) began Market Misconduct Tribunal proceedings against CITIC and five former directors over the 12 September 2008 circular, and separately sought roughly HK$1.9 billion in compensation for about 4,500 investors who bought shares between the circular and the profit warning. The Tribunal's report, delivered on 10 April 2017 after a lengthy hearing, found that the SFC had not proved market misconduct under the relevant section of the Securities and Futures Ordinance. The Tribunal found the 12 September circular was technically accurate given its narrow legal scope, while still noting in its concluding remarks that CITIC had used risky derivatives, waited nearly six weeks after recognising the exposure before telling the market, and accumulated a mark-to-market loss of about HK$14.7 billion.

This case sits at the centre of Lecture 5's lesson on how forward-style hedges are supposed to work: the notional size and payoff shape of a hedge must match the underlying exposure, or it stops being a hedge. It also speaks to Lecture 9's theme of product complexity and disclosure. The accumulators were structured so that even senior management, by their own evidence, did not fully appreciate the risk until it had already grown very large, and the gap between recognising that risk and telling the market about it became the subject of a formal legal process that ran for nearly a decade.

A target redemption forward looks, at first glance, like a string of ordinary forward contracts settling monthly. The difference lies in what happens on each side of the strike rate. Above the strike, CITIC buys its normal amount at a favourable rate, but the contract knocks out once cumulative gains reach a cap, so the benefit of a rising currency is bounded. Below the strike, there is no such cap. CITIC must buy a multiple of the normal amount, for example 2.5 times, at the unfavourable strike rate. The two sides of the same contract are not mirror images of each other: one is capped, the other is leveraged and open-ended.

That shape amounts, in effect, to a package of FX options CITIC sold to the counterparty banks rather than bought from them. Selling optionality brings in an attractive-looking rate on the way up, which is why these products can be marketed as "cheaper" or "zero cost" hedges. The real cost shows up only in the tail, when the currency falls, and it appears as a multiplied, uncapped loss rather than a cash premium paid up front.

A second problem compounded the first: scale. A hedge is supposed to be sized to the underlying exposure. CITIC's real, ongoing need for Australian dollars was AUD 1.6 billion over the following two years. Its contractual obligation to buy Australian dollars under the TRF contracts was AUD 9.44 billion, nearly six times as large. Once a "hedge" is several times bigger than the exposure it is meant to offset, it is no longer reducing risk. It becomes a directional bet, dressed up in the vocabulary of risk management, that the currency involved would keep moving in one direction.