FT Summer School – A Risky Weapon in the Corporate Armoury-

“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 <?xml:namespace prefix = st1 ns = “urn:schemas-microsoft-com:office:smarttags” />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. <?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />