by Christopher Culp
August 21, 2003

"Derivatives have become associated with recklessness following several
high-profile bankruptcies, but they can be an effective way of managing
risk," says Christopher Culp.

In his March 2003 letter to Berkshire Hathaway shareholders, Warren
Buffett described derivatives as "financial weapons of mass
destruction."  Mr. Buffett is by no means the first such critic of
derivatives. More than 200 proposals to prohibit, limit, tax or
regulate them appeared in the US in the last century, and Enron's
active participation in derivatives has exacerbated popular fears of
these products.

Derivatives are financial instruments whose pay-offs are based on the
performance of an underlying asset, reference rate or index. Popular
types include futures, forwards, options and swaps. Like all financial
instruments, they create potential benefits and risks for their users.
We will examine both in an effort to get past the hyperbole and judge
when derivatives make sense for corporate use.

Rather than calling derivatives weapons of mass destruction, we might
equally describe them as smart bombs that corporations can use
precisely to remove unwanted risks. In most cases, the risks to which a
business is naturally exposed are greater than the risks that
shareholders perceive as essential to running that business.
Derivatives can be used to surgically remove non-essential risks.

Derivatives are available for almost all main asset classes and can be
used by companies to manage interest rate, exchange rate, commodity
price, equity price and credit risk, among others. Corporations can
benefit from using derivatives in several ways. Most obviously, they
can help reduce the expected costs of financial distress by insulating
companies from catastrophic losses. Further, by enabling managers to
reduce risks that are not essential to their core businesses,
derivatives allow managers to spend more time running their companies.

Derivatives are appealing tools of risk management in part because they
are so flexible. Companies can use them to manage assets and
liabilities, reduce the volatility of cash flow, maintain profit
margins, reduce "noise" in accounting earnings and more. Derivatives
are usually cheaper than comparable cash market transactions. A
corporate pension planner with a long-term equity position who is
worried about a temporary correction in the stock market, for example,
can "synthetically" reduce his or her equity exposure by selling
futures, usually at a much lower cost and with less market impact than
if the plan actually sold stocks.

They may also have wider benefits to the financial system. As
derivatives reduce the vulnerability of companies to wild fluctuations
in market prices, the financial system as a whole becomes more
resilient to corporate defaults, business cycle fluctuations and the
normal volatility of the market process.

Yet derivatives can cause devastation if they are not handled properly.
For example, they allow companies to reduce their market risk, but in
so doing expose them to credit risk. If a company wants to manage its
funding risk on an outstanding issue of floating-rate bonds, for
example, it can enter into a pay-fixed interest rate swap. But the
company has only reduced its interest-rate risk if the swap
counterparty actually makes its required payments. Interest-rate risk
on the bonds has been transformed into credit risk on the swap.

Credit risk, of course, can be managed using tools like collateral or,
increasingly, credit derivatives specifically designed to provide
credit risk protection against specific company defaults. But companies
still face credit risk from the provider of the credit protection.
Enron, for example, was a significant provider of credit default swaps.
And, as Enron's counterparties discovered, buying credit risk
protection on one company does not work very well when the protection
provider itself fails.

Derivatives also expose users to operational risks ranging from
tracking cash and settlement dates to internal control failures that
permit fraud, trading abuses and the like.

Despite the appeal of derivatives in hitting their marks, the right
mark still has to be painted. In the mid-1990s, a number of corporate
treasurers used derivatives to bet that short-term interest rates would
stay low relative to long-term rates. When short-term rates rose
instead, the companies lost hundreds of millions of dollars by aiming
at the wrong interest-rate target.

Companies can also find the liquidity risk of derivatives painful.
Exchange-traded derivatives, in particular, are margined and resettled
as often as twice daily. When used to hedge an asset or liability with
deferred cash flows, a company can find itself facing "hedger's ruin"
if it cannot meet the payments on a losing futures hedge. Left to run
its course, a hedge might work, generating cash outflows that will be
covered by the eventual inflows. But if a liquidity crunch forces the
company to terminate the losing hedge early, the hedger may well end up
turning paper losses (that would otherwise eventually have been offset
with as yet unrealised gains) into real losses. This is a part of the
complex story of the $1.3bn (£808m) loss booked in 1993 by
Metallgesellschaft on its US oil marketing and hedging operation.

Many of these risks are no different from the risks to which other
financial activities expose companies, and most can be addressed
through a judicious and sound risk management and internal control
process. Some critics of derivatives, however, contend that certain
derivatives risks are "systemic" in nature and thus transcend the
preventive controls of an individual company's risk management process.
The failure of a big derivatives dealer, for example, could spread
across other companies and precipitate global payment system gridlock.

This is a plausible scenario, though highly unlikely. The failures of
large companies, such as Bankhaus Herstatt, Drexel Burnham Lambert,
Barings, Long-Term Capital Management, and Enron all resulted in
relatively little market disruption. Indeed, in the case of companies
like Drexel and Enron, derivatives generally mitigated the impacts of
the failures.

Calls for controls over derivatives are as old as derivatives
themselves. England's 18th-century Corn Laws, for example, were adopted
in part to discourage derivatives-like activities in corn markets
called "forestalling and engrossing". Adam Smith's defence of
derivatives in his "Wealth of Nations" is as appropriate now as it was
then: "The popular fear of engrossing and forestalling may be compared
to the popular terrors and suspicions of witchcraft. The unfortunate
wretches accused of this latter crime were not more innocent of the
misfortunes imputed to them than those who have been accused of the
former."

Misfires involving derivatives will occur: Barings did blow up,
Metallgesellschaft did book a $1.3bn loss, and so on. But we should be
careful not to confuse flaws in corporate risk management and internal
controls or poorly selected risk targets with flaws in derivatives
themselves.

Indeed, perhaps the greatest risk of derivatives to a company is the
risk of not using them when it is appropriate to do so. Companies would
then be forced to bear all the risks to which their businesses expose
them, leaving shareholders scrambling to manage those risks on their
own or, worse, leaving shareholders vulnerable to the full impact of
adverse market events. In that world, every single precipitous market
move could become a financial WMD. Far from being WMDs, derivatives may
well be a corporation's best defense against them.